Landing Seed Capital from Angel Investors – A Guide for Sustainable Entrepreneurs

Wealthy individuals have always been benefactors of fledgling businesses, particularly when a company is involved in an area in which the individual has substantial prior experience. Recently, however, increasing focus has been placed on so-called “angel” investors, who are high net worth individuals, often businesspeople or professionals with high incomes or individuals from wealthy families who seek high-risk/high-return investment opportunities.  The angel investor community has also been buoyed by the entrance of individuals who have previously been involved as founders and/or senior executives of successful businesses and who exited those businesses with significant sums of money from a public offering or acquisition by an outside party. Some of the key characteristics of angel investor preferences and contributions include the following:

  • Angel investors are willing to accept more risk and to provide small amounts of money to allow the entrepreneur to develop the company’s business plan and complete work on new product prototypes that can be shown to venture capital firms and potential business partners. Venture capitalists generally prefer to make fewer investments and each investment must equal or exceed a certain minimum amount to justify the time and effort that the venture capitalist will spend on the company. In contrast, angel investors (alone or as part of a group of several investors) are often able to provide seed capital in amounts ranging anywhere from a few thousand dollars to several million dollars.
  • The due diligence and negotiation process for taking capital from angel investors is generally much shorter and simpler than similar activities with venture capitalists.
  • Angel investors are generally more patient than venture capitalists and less likely to require a rapid exit from the investment. Also, the required rate of return for many angel investors is lower than the requirements of venture capitalists, which must satisfy their own investors in order to raise new funds.
  • Angel investors tend to place greater emphasis on the attributes of the entrepreneur and personal chemistry, and are more likely to get involved with a company due to interest or experience in a particular industry and their desire to bring their network of contacts to assist the company.
  • Angel investors tend to be more proactive than professional investors in providing “hands on” assistance to their portfolio companies, thereby helping to strengthen the skill base of the firm’s management team. Studies have shown that primary assistance from angel investors is in the area of general strategic advice and in specialized areas such as marketing, finance and accounting.

This article is adapted from material in Seed Capital: A Guide for Sustainable Entrepreneurs, which is prepared and distributed by the Sustainable Entrepreneurship Project and can be downloaded here.

However, while angel investors can be an attractive alternative, particularly since closing the deal with an angel is usually quicker and easier than it is with a venture capitalist or institutional investor, an obvious problem is that angel investment alone is generally not sufficient to permit portfolio companies to bring their products to the marketplace. Angel investors are not good sources of capital to build out manufacturing facilities or marketing and distribution channels; these projects are best left to larger investors once the product or service has been polished and verified. In addition, angel investors can be difficult to locate; however, various networks and organizations of angel investors have been formed to ease the process of matching investors with opportunities. At a deal-specific level, entrepreneurs must also be mindful that angel investors may not be able to provide the extensive network of contacts and resources that venture capital firms make available to companies that join their investment portfolio. Also, while the personal chemistry between the investor and the founders may be good, the actual experiences and specialties of the angel investor, such as marketing, may not be a good fit for the needs of the company, thus reducing the actual “value add” provided by the angel investor. Angel investors also impact the equity positions of the founders and may cause disruptions in management and control of the company. Finally, while angel funding is less formal than a venture capital transaction, the company and its principals must still comply with applicable laws and regulations with respect to disclosures and the manner of offering regardless of the actual size of the investment.

If, after taking all of the factors mentioned above, a decision is made to move forward with an angel financing round, consideration should be given to which of several financing structures might be appropriate for the company and the investor group.  Some of the alternatives that might be used include the following:

  • Common stock, the same form of equity instrument issued to the founders and set aside for employees, may be sold to the angel investors at an agreed valuation; however, this approach as drawbacks for almost everyone. The investors have none of the protections that will inevitably be given to the next group of outside investors who demand and received preferred stock and the company will have set a valuation for the common stock that undermines its ability to issue stock options with attractive exercise prices to employees, advisors and others needed to assist the company in getting off the ground.
  • The most common form of investment instrument for angel investors is probably a convertible note that provides for automatic conversion of the principal and accrued interest into the company’s initial preferred stock financing round provided that certain requirements with regard to that financing are satisfied (e.g., size of the round and closing on or before a specified date). In order to reward the angel investors for the risk that they took on to finance the company at an early stage, the conversion rate will reflect an agreed discount from the price paid by the preferred stock investors.  They will also gain the benefits of all of the rights given to the preferred investors, including the full liquidation preference even though a discounted price has been paid.  Early investors may also receive warrants and other benefits.
  • A twist on the traditional convertible note is the so-called “capped” convertible note that provides for conversion into the first round of preferred stock financing at either an agreed discount or at an agreed capped valuation, with the outcome based on what provides the most benefit for the angel investors. Assume, for example, the angel investors have agreed that upon the closing of the preferred financing a 25% discount and $3 million “cap” would apply.  If the pre-money valuation at the closing is $2 million, the notes would convert at a per share price determined as if the pre-money valuation was $1.5 million (i.e., the 25% discount would apply).  If, however, the pre-money valuation was $5 million, the cap would apply and the conversion would occur at a per share price determined as if the pre-money valuation was $3 million rather than 75% of $5 million (i.e., $3.75 million).
  • Some angel investors and law firms have suggested “light” preferred stock as an appropriate way to provide early stage funding instead of convertible notes, arguing that fairly simple terms can be created as an “industry standard” to facilitate efficient preparation of documents without too much expense. Light preferred stock instruments go by a variety of names, including Series AA Equity Financing, Plain Preferred and Series Seed Financing.  In reality, however, no standard has emerged from among the various examples that have been proposed and angel investors have also complicated the process by becoming more aggressive about receiving management rights and legal opinions.

As the challenge of closing the initial round of funding from venture capital investors increased the demand from founders for financing at the early development pre-revenue stage led to the emergence of seed capital funds that purport to specialize in seed round financings ranging from $25,000 to $2 million.  The size of these seed capital funds varies from $5 to $50 million and while some of them have raised money from the same institutional investors that participate in larger venture capital funds it is more common to see seed funds being support by capital obtained from wealthy individual investors, sometimes referred to as “super-angels” who have made investing in startups their full time passion and are well known in the startup community, and smaller family endowments.  The principals of the seed funds typically argue that they will be able to give more attention to smaller companies than the larger venture capital firms and thus be able to guide the founders of those companies through the milestones that needed to achieve in order to secure the interest of venture capitalists and close the elusive Series A round.  The reality is that many of the promotors of the seed capital funds lack the experience and external relationships found among larger venture capital firms to provide meaningful assistance to their portfolio companies.  In particular, many of the seed capital funds lack the strong relationships with venture capital firms that would be helpful in securing additional financing for their investees.  As a result, data shows that companies that obtain seed financing only from seed capital funds have more difficulty in closing a Series A round than those companies that have forged financial and business relationships with larger venture capital firms that also invest a portion of their available capital in seed stage deals.

While founders should exercise care in vetting potential seed capital fund investors, there are several funds who have carved out a strong reputation for their focus on seed-stage companies in specific geographic areas and/or industry sectors and their ability to provide funding, accelerator programs and entrepreneur events.  Go observed that while there are now a large number of funds willing to consider investing at the seed stage, not all of them are positioned to “lead” deals.  Go suggested that the capacity of a seed fund to act as a lead is constrained by the number of partners and the time and effort required to do spot promising ideas, interview the founders, conduct due diligence and contact the references provided by the founders, draft and issue a term sheet and coordinate finalization of the terms with other investors.  According to Go, the best lead investors limit themselves to less than six investments per year per partner and are typically willing and able to get everything done in a few weeks and provide the founders with regular reports on their progress.  Go cautioned that if an investor is not willing to commit to an efficient and transparent deal process, or does so and then disappears, it is a sign for the founders to look elsewhere.  Go also advised that founders should not waste too much time on convincing investors who are skeptical about the proposed business model and that the fundraising efforts should be focused on identifying the “true believers”.

This article is adapted from material in Seed Capital: A Guide for Sustainable Entrepreneurs, which is prepared and distributed by the Sustainable Entrepreneurship Project and can be downloaded here.

Alan Gutterman is the Founding Director of the Sustainable Entrepreneurship Project, which engages in and promotes research, education and training activities relating to entrepreneurial ventures launched with the aspiration to create sustainable enterprises that achieve significant growth in scale and value creation through the development of innovative products or services which form the basis for a successful international business.  Visit the Project’s Library of Resources for Sustainable Entrepreneurs to download handbooks, guides, articles and other materials relating to sustainable entrepreneurship and keep up with the Project’s activities by following Alan on LinkedInTwitter and Facebook.

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