Key Takeaways:

  • Angel investor agreements are essential for defining the relationship between investors and startups, covering critical elements like equity distribution, voting rights, and exit strategies.
  • Key clauses in these agreements include equity stake and dilution, board seat and voting rights, liquidation preference, anti-dilution protection, conversion rights, exit strategies, information rights, and vesting schedules.
  • Common mistakes to avoid include neglecting legal advice, inadequate exit clauses, weak anti-dilution provisions, unclear equity terms, and failing to consider future funding rounds.

Angel investor terms are used to define the relationship between an investor and the company receiving the investment. The terms of this type of agreement are established with a non-binding document called a term sheet. This is similar to a letter of intent as it creates the intention of moving forward with a partnership and often leads to a legally binding agreement.

What Is Included on a Term Sheet?

The term sheet for an angel investor is usually about 10 pages long, compared to 20 pages or more for a venture capital term sheet. These pages summarize the deal's proposed terms and can be used to attract potential investors and as a guide for attorneys to create the legally binding investment agreement.

Term sheets often contain complex legal language, so less experienced individuals should consult an attorney. The provisions of a term sheet contain anti-dilution protection, drag-along rights, liquidation preferences, board composition, investment round size, and share pricing. Elements to consider include:

  • The deal must be beneficial enough for the investor that he or she is willing to take on the associated risk. The investor wants to avoid dilution and ensure first return on their investment.
  • Investors want to avoid terms that allow future deals to diminish the value of their investment or make them lose liquidity priority.
  • Some investors may want to have some control over the company, including influence on critical decisions.
  • Investors will want to ensure that they receive their investment back in all positive and negative investment scenarios.

The term sheet should be structured in such a way to make the deal a win-win for both parties.

Understanding Angel Investor Agreements

Angel investor agreements are critical legal documents that outline the terms and conditions between an investor and a startup. These agreements are not just about securing funds; they serve as a roadmap for the relationship between the entrepreneur and the investor. The key elements of these agreements include the investment amount, equity distribution, voting rights, and exit strategies. A well-drafted angel investor agreement helps in avoiding potential conflicts and ensures that both parties are aligned with the company's long-term goals.

It's important to customize these agreements based on the specific needs of the startup and the investor, rather than relying on generic templates. Consulting with a lawyer who specializes in startup investments can help ensure that the agreement is robust and fair to all parties involved.

What Is Seed Capital?

Often provided by the company's founder and his or her friends and family, seed capital is the initial funding source for a new business. This occurs before any major investment rounds and is known as the seed stage. Often, the company in question is not yet profiting or is earning only a small amount of revenue. The seed stage helps to build the business and generate the interest of venture capitalists.

How Is a Startup Valued?

The value of a new business is established based on the price someone else would be willing to pay for the company on the open market. Types of valuation include:

  • Pre-money valuation, which is the worth before an angel investor puts money into the business
  • Post-money valuation, which is the worth after you receive a cash infusion from an angel investor

A startup undergoes valuation before every round of funding. Often, entrepreneurs accept a lower price per share in exchange for added flexibility.

Key Clauses in Angel Investor Agreements

When drafting an angel investor agreement, several key clauses must be carefully considered:

  1. Equity Stake and Dilution: This clause outlines the percentage of equity that the investor will receive in exchange for their investment. It is also essential to address how future fundraising rounds might dilute this equity.
  2. Board Seat and Voting Rights: Investors may request a seat on the board of directors or specific voting rights to influence major business decisions. This clause defines the extent of the investor’s control in the company’s governance.
  3. Liquidation Preference: This clause determines the order in which investors get paid in the event of a liquidation. Typically, angel investors may have a preference over common shareholders.
  4. Anti-Dilution Protection: To protect their investment, investors often include anti-dilution provisions that adjust their equity stake if new shares are issued at a lower valuation.
  5. Conversion Rights: If the investment is structured as a convertible note, this clause will outline the conditions under which the note converts into equity, including any discount rates or valuation caps.
  6. Exit Strategy: This outlines the scenarios under which the investor can exit the investment, such as through an acquisition, IPO, or buyback by the company.
  7. Information Rights: Investors often request regular updates on the company’s financial status, operations, and other critical metrics. This clause specifies the type and frequency of the information that must be provided.
  8. Vesting Schedule: If the founders’ shares are subject to vesting, this clause details the schedule and conditions for the vesting process.

How Do Stock Holdings Work?

Your company can issue many stock classes, each with its own rights. For example, preferred stock can be issued to investors and allows them to receive dividends with priority over common stockholders. Common stock is often issued to employees and founders.

A detailed list of stock ownership by individual and entity is called a capitalization table. It lists the ownership percentages of each owner, which must add up to 100 percent. Think of the capitalization table as a spreadsheet of sorts.

Owners earn their stock holdings over time through a process called vesting. This provides the original founders and owners a reason to stay with the company. For founders and employees, the vesting period is often three or four years. If the person leaves before the vesting period is over, a portion of the stock will be returned to the company.

When you give another individual or business part of your company's stock, this is called dilution. You now own less of the company to make room for another owner.

When your company receives a loan that can be repaid with stock, this is called a convertible note. This type of loan has a maturity date and an interest rate; it can often be converted at a discounted rate in the future.

Often, an investor will require a certain percentage of stock shares to be dedicated to future employees through a stock option pool. This also dilutes your ownership stake and can range from 5 to 20 points of equity depending on the agreement.

Common Mistakes to Avoid in Angel Investor Agreements

While angel investor agreements are crucial for securing funding, startups often make several common mistakes that can have long-term repercussions:

  • Overlooking Legal Advice: Startups may attempt to cut costs by using standard agreements without consulting a lawyer, leading to unfavorable terms or potential legal issues.
  • Neglecting Exit Clauses: Failing to define clear exit strategies can result in disputes when investors wish to exit the investment, especially if the company’s valuation has changed significantly.
  • Inadequate Anti-Dilution Provisions: Without strong anti-dilution clauses, early investors may find their equity significantly diluted in later funding rounds, leading to dissatisfaction and potential conflicts.
  • Unclear Equity Terms: Ambiguities in equity distribution and dilution can create misunderstandings between the startup and the investor, potentially harming the relationship and the business.
  • Ignoring Future Funding Rounds: Failing to account for future funding needs and how they will impact existing agreements can lead to issues with investor relations and equity management.

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