Wednesday, February 2, 2011

How I See It

Stop, listen and get creative to gain angel financing

By Lawrence H. Gennari, partner at Gennari Aronson LLP

Even in these challenging economic times, angel investors can provide an essential source of funding for emerging businesses. In fact, angels often fill the gap between funding from friends and neighbors and a first round of venture capital.

So, once you have found a potential angel investor, how do you seal the deal? Some entrepreneurs turn to the web for sample term sheets or use “standard” documents provided by other colleagues or advisors who might be trying to help. That’s a huge mistake. Terms for angel investments are as wide and varied as the angels themselves, and entrepreneurs should stop and listen before they lay out specifics for investors. Otherwise, you may be giving away more than you know, and you may not get a check.
Angels typically want terms to cover three basic concerns: control, dilution and current value or return.

Control. For many angels, control over how their money is invested in operations is a hot-button issue. One of the “standard” solutions is to offer the investor a board seat to allow them to monitor their investment. This may not be ideal, especially if the angel director has little relevant experience in the company’s market segment. It may not even be necessary. Consider a less permanent alternative such as an investor veto over the scope of some cash expenditures during the next fiscal year. Better yet, what about an appointment to an advisory board, which could meet regularly to discuss results, trends and developments, but which would lack the formal decision making authority of a board of directors. Remember that even the most control-oriented investors might be satisfied to observe at periodic formal meetings, without being appointed as a voting board member.

Upside/dilution. Some angels worry less about day-to-day control, but they are concerned about being diluted and owning less of the company as it completes future financings. Here too, common wisdom might suggest that investors get detailed anti-dilution rights in incorporation documents. That’s not always the answer. What’s more, these same rights probably have to be renegotiated if a later-stage venture investor comes along, often at great time and expense for the entrepreneur. A less problematic solution can be crafted for angel investors. Why not offer angels a preemptive right to buy more shares to maintain their percentage ownership or even a right of first offer if the company needs more capital. Even if an angel demands anti-dilution rights, entrepreneurs should try to limit those rights or make them go away after a more significant financing round. Finding a targeted solution rather than settling for a standard form will allow more flexibility. 

Current value. Some angels seek near term returns, instead of longer term appreciation. These concerns impact everything from structure of the company to the actual security that might be offered. This investor might be interested in modest but regular cash dividends or a percentage of first revenues, instead of waiting for an IPO or company sale. Indeed, a limited liability company or S-corporation structure with special provisions might let them take regular cash distributions or show some company losses on their individual tax returns in the near term. Alternatively, the company could issue custom notes that are to be paid back with interest — instead of “standard” preferred equity shares — to close an angel round. More aggressive “current value oriented” investors might prefer convertible debt, with an option to convert notes at a discount on a subsequent round as a bonus. In any event, these investors might balk if they are only served the typical offering of capital stock.

The good news is that angel investors are more active than ever, And companies are finding their way to them. Just remember that fitting the deal to the angel is as much art as science — and getting it right is the key to getting a check.

 

Lawrence Gennari also is an adjunct professor at Boston College Law School.