Common Term Sheet Missteps Made By Novice Angel Investors
Angel investors are often attracted to early-stage investment opportunities by the high return (ROI) potential. Early-stage investors also assume the full risk of failure of the venture, often losing their entire investment. One mechanism to mitigate some of the risks and provide protections during a company’s early development is through a well-negotiated investment package and Term Sheet. Active angel investors regularly work with term sheets, but not every investor fully understands the language in these highly specialized documents. Each investment deal is unique and requires some level of customization. The problem is that investment packages can be dense and complex; term sheets cover dozens of subjects. To help you avoid some of the most common missteps made by early-stage investors, this article breaks down what you should look for before writing a check.
Legally Binding Terms. Investors need to fully understand the terms and conditions described in the term sheet and accept that they are entering into a legally binding agreement when they complete the subscription agreement and hand over their check. The term sheet is just one of the deal documents, and most early-stage investors would do well to work with their attorney to make sure that the terms are acceptable and complete. To be clear — no matter what the entrepreneur tells you — ONLY the written terms have meaning and force in the agreement between the company and its investors. If you are not working with an angel investment group, you will likely not have control of the investment documents, and every investment will be a new reading challenge. If you are with an active group, there is a good chance that they will be leading the investment and will be supplying the investment documents and negotiating the term sheet, always an advantage to the investors.
First in Line.
As an investor, you want to protect your share of the venture, looking to get your returns early and often. There are just 3 types of equity you can invest in; Common, Preferred, and Participating Preferred, and whenever possible, you want to ensure that you are first in line when a company issues distributions. Investing in a deal with Participating Preferred equity typically guarantees that you will get your investment back first and then participate ratably in the rest. The term sheet that I most commonly work with is a participating preferred term sheet offering investors a 100% (1X) return on their investment, followed by a pro-rata share of the remaining distributions. A Preferred equity deal often offers the 1X only upon the liquidation (winding up) of the company, followed by a percentage of any remaining funds. Common is, well common, with no pre-emptive rights in distributions.
I see many term sheets that offer what I refer to as non-participating preferred equity — you get your 1X (or sometimes 2X) return but don’t share in any excess unless you waive your preferred position and just take a pro-rata share of the distribution. This protects the downside if the company fails, and there is a sale of assets, but if the company is successful and reaches a positive liquidity event, you lose your preferred position. I try to point out to entrepreneurs that, without my investment, there will likely not be a successful company — if I am willing to take the risk of investing, I should also reap the rewards.
Protection in Future Rounds. As an investor, you want to make sure future financing deals contain terms that do not unduly dilute your investment value or lead to someone moving into a superior liquidity position. If I am to lead the investment round on behalf of an angel group, I want to lead the follow-on round as well so that we can protect as much of the position as possible. That allows all investors to co-mingle the rounds and offer equal protection to the investors in both fundings. A strong term sheet will pave the way for these kinds of protections.
Even if I don’t lead the follow-on round, a good investment will prevail. Let’s take a look at a simple example; if the company is successful in growing and getting its products to market, a follow-on round will almost always dilute your percentage holdings in the company, but the new investors are likely paying more per share of stock than you did and they are buying in at a higher company valuation than you did. If you invested at $1.00 per share at a $2m valuation and the next round of investors are paying $2 per share at a $4m valuation, your position is exceptional — your shares have doubled in value! You now have the right to “double down” by investing in the new round if you want to preserve your percentage holding in the company, so long as the term sheet includes pre-emptive rights — something I always include in my negotiations.
Other provisions can attempt to control behavior more directly. The first is an assertion of the right to approve any material merger, acquisition, or liquidation of the company. The inclusion of a strong anti-dilution clause should say that if a subsequent round happens at a lower price (often referred to as a down round), the earlier investors’ purchase price is adjusted retroactively, and the original investment is recalculated based on the lower price. In effect, you get more stock for the initial investment.
Advisory. An investment package should protect against founder behavior that could be damaging to the company. Significant investments may call for an investor Board seat combined with governance provisions requiring board or committee approval for a list of important operational activities (or even in some cases reserving a veto right for the investor board member).
The investor board seat is usually not term limited. However, the expectation and custom are that as additional investor directors are added through additional larger rounds of financing, and the board grows unwieldy, that some early investor directors may drop down to being observers, or may roll off the board entirely in the belief that it is best for the company.
If the investment level does not warrant an investor Board seat, it is essential to require that the company regularly share investors’ information on the company’s financial and business condition. Although some CEOs will voluntarily update investors as frequently as once a month, most information rights clauses merely obligate the company to provide quarterly management reports with some financial or management dashboard data.
Protect Your Right to a Return. As an investor, you want to maximize the chances to get a return on your investment in all possible exit scenarios. Not all your investments will be home runs, and not all will outright fail. Some of your investments may turn out to be great lifestyle businesses — great for the founders and the management team — but marginal at best for the investors.
This is where the astute term sheet negotiator shines! By adding a “Put Right” in the term sheet, it protects the right, typically after 5 years, to force the company to buy back the equity at the current value if they have not returned the original 1X investment. Additionally, investing in a company that becomes a strong lifestyle business can be a great investment if it is passing profits to investors via distributions. I hold a company in my portfolio that, in a single distribution, returned 4.4X to us due to a $100m distribution! And I still have equity!
Even experienced investors find there is a lot to learn when they become angel investors. One way to mitigate missteps is to become a member of an organized angel investment group. An angel group, like Keiretsu Forum Mid-Atlantic, will attract people with more in-depth and broader experience, who will bring their larger perspective to the deliberation and decision-making process. As an individual angel investor, you are now able to leverage the advantage of a team of people performing diligence on the company and its business model. When angel groups collaborate on a deal, the diligence team inevitably becomes more substantial and more experienced, which makes for better decision making and fewer missteps.
The best way to avoid the missteps often made by a novice angel investor is to join an angel investment group to build a foundation for your portfolio. The collaboration and collective diligence from group members will put you on sure footing. There are angel groups that specialize in particular business silos or only invest in Founders from a particular gender, ethnicity, or geographic region. I strongly recommend- and research supports my advice- to optimize the return in angel investing, build a portfolio of twenty or more deals representing diverse silos and geographies.
Good luck.
The author:
Howard Lubert, Founder Keiretsu Forum Mid-Atlantic, South-East, and Accelerator Venture Partners Fund
Howard Lubert continues to build upon a strong foundation of successes in angel investing, which began while at Safeguard Scientifics. In his career working with early-stage companies, Howard estimates that he has seen over 10,000 pitches across every business silo. His experience working as a Fund Manager and as a private angel investor gives him an exceptional vantage when assessing new deals.
In 2010, Howard founded Keiretsu Forum Mid-Atlantic. “Keiretsu” is the Japanese word for a family of affiliated companies that form a tight-knit alliance and work toward each other’s mutual success. Consistent with this definition, Keiretsu Forum is a conglomeration of serious investors, business leaders, venture capitalists, corporate & institutional investors and serial entrepreneurs bound by overlapping and co-dependent goals to work together for each other’s mutual benefit, form strategic partnerships, enhance each other’s knowledge and build an angel network of diverse skills.
For additional information, go to www.KeiretsuForum.net or email info@keiretsuforum.net.
