Angel Investor Series- Structuring

Hi Friends,

In continuation of my angel investor series, this week I am going to talk about structuring.  The first important item to know is that winning investors do not always agree on structuring of a deal.  Some angels believe that structure is essential and will take a hands-on approach to negotiating structure.  They might also be evaluating the deal based off the proposed structure of the deal.  These angels are very likely to put their mark on the price and the deal structure.
Angels who are a part of the other school of thought believe that structure is irrelevant.  They will simply take whatever is offered whether it is common stock, preferred stock, or convertible notes.  These angels will make their judgements whether the deal will succeed or be a beautiful failure.  They know that if it succeeds, they will do just fine without any protections.  If it fails, the salvage operations will not be worth their time or energy.

Angels use various structures when investing and there are three that are used the most often which are:

Common stock- this option is offered by angels who rely on the integrity of the entrepreneur and their own ability to source and evaluate the deal they are making.  This structure is the most simple and it has its advantages.  You want to use this with someone that you know is reasonably sophisticated and they are a quality person.

Preferred convertible with various terms- this option is common among venture capitalists and countless angel investors.  “This structure is not that simple and will require some significant interaction with the entrepreneur in the hoped-for event that additional capital is raised or an exit obtained.” (David and Stevenson, 192).  This structure also offers more protection to the investor than common stock, which is why we see so many venture capitalists using it.

Convertible note with various terms- this option is becoming much more popular in fields where things move much faster and there is shorter periods.  This structure will require interaction with the entrepreneur but it can be simple interactions.  Venture capitalists are not the biggest fans of this structure because they do not like if the percent discount is high.

The authors give some simple rules that you should follow when planning the structure.
1.) Keep it simple- this will ensure that everyone can understand the structure and it will not limit the management team’s abilities and aid new investors to come to a new deal in a reasonable amount of time.

2.) Do not restrict the company’s ability to do future deals- You should avoid restrictions on future dealing that you put in place to protect yourself against value discrimination or unreasonable dilution.  You will only harm yourself.

3.) Make sure the valuation is reasonable- Do not set your first valuation high because you will run out of gas right out of the gate and additional investors will not want to come in during the first round.  You also run the risk of the old investors and stock-holding employees to be unmotivated if you come back at a better rate.

I think this was my favorite section so far that we have read.  I found it very interesting and loved learning about how to structure your deal, both as an investor and as an entrepreneur.  I think the rules were very helpful and I found it witty how the authors gave you the deal terms as a menu on pages 185 through 188.  What structure would you go for as an investor?  What about as an entrepreneur?

Thank you for stopping by and reading my blog. 

Until Next Time,
Dani References:

Amis, David, and Howard H. Stevenson. Winning Angels: the Seven Fundamentals of Early-Stage Investing. Financial Times Prentice Hall, 2001.

12 thoughts on “Angel Investor Series- Structuring

  1. Jose F Saavedra

    Dani,
    Your post greatly sums up the key highlights of the Structuring discussion. I agree with your closing statement, this chapters (well, the book in general) provide a great window into investor’s mindset as to what might be going through their minds as a deal is being structured and negotiated. I would say that each investment deal might need a different structure depending on the industry, but I would lean towards keeping things simple… aka, Common Stock! I think it provides many of the benefits of the traditional structure and you always have the possibility to restructure once the next funding round comes around.
    Best regards,
    -Jose F. Saavedra

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  2. kayreyna

    It is interesting to note that some angel investors as you said, “…believe that the structure is essential and will take a hands-on approach to negotiating structure.” And that some angel investors do not and believe that the structure is irrelevant making their decisions based up whether as you said, “…the deal will succeed or be a beautiful failure.” Such a contrast in thought.

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  3. Tony

    Your comments around the value of Structuring are interesting. We started this course focusing on networking and building relationships. The Evaluation of an opportunity is about understanding the entrepreneur. While I understand it is business and not focused on friendships, it would seem that some level of trusting relationship should exist. Considering very large deals there will likely be financial and legal professionals engaged to help define the opportunity and guide on structures. Where the deals are smaller and investors are closer to the deals, I think the structure may benefit from a more trusting relationship. Although I admit I am not a burned or seasoned investor, so my perspective is limited. Thanks for the read.

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  4. AK

    Dani,

    Interesting reflection – it was very thoughtful in regard to how investors approach structuring deals. “It will either succeed or be a beautiful failure.” I love that paradox of the “beautiful failure.” It’s such a contrasting concept that it becomes a beautiful idea on its own honestly.

    Most certainly keeping it straightforward at the beginning is good in preparation for future rounds. Although, I would for sure feel more comfortable that in the event everything suddenly goes in an unpredicted direction that I would have legalities in my favor to protect my losses.

    Thanks,
    AK

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  5. exwalton1

    Dani,

    I think that it was interesting to read the opposing views of investors regarding structuring. If I were an investor or an entrepreneur I would choose the preferred convertible structure. As an investor I would want to get funds as soon as possible and as an entrepreneur I would also want the investor to get theirs for investing in me and my company.

    Essence

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  6. Michael Walton

    It is interesting that your thoughts on this particular reading differed so much as compared to my own. For example, you really enjoyed this section while I was thinking “Wow, this is really over my head”. I had to do a significant amount of research to understand stock versus preferred convertible, versus convertible note with various terms. Quite the mouthful and confusing to me. What does “various terms” mean? Based upon the reading that could mean just about anything. If the agreed term is that the angel wants a 10% stake in future investment opportunities, or they want to ensure that ice cream is delivered to their house each summer Sunday afternoon, the “terms” are wide open. In my writing I referred to this section as KISS, Keep It Simple Stupid. Not that anybody was “stupid”, it was just over my head.

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  7. Tom Huchko

    Dani,

    I completely agree! Sometimes you must be willing to sacrifice things in order to make the entire deal work for everyone. A lot of times I am sure this comes in the form of rules or levels of freedom the entrepreneurship team has.

    You did a great job of explaining the stock options. Personally, I would probably be more likely to lean towards the lenient side of investing. I know that if I believed in a company, I wouldn’t care as much about kind of stock I have, I would just know that its going to work and we will all win in the end.

    Thank you,
    Tom

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  8. jbbailey11

    Hey Dani,
    I like that you made it easier to ready the definition of the types of structures. I feel that I have a few investors who will agree to have a common stoke type structure to our partnership. Great reflection.

    Like

  9. Turner Votipka

    Dani,

    I must say that asking a question at the end of it all is a tactic that I may start doing, simply because we all need to respond and it is super helpful to just be able to answer a question. Thanks for doing that, and I might steal that idea! For my, as an investor I understand the purpose behind negotiating certain types of structured deals in order to protect myself but I would prefer to do common stock as an entrepreneur so that I am not overly confined. Freedom is important, in my opinion, for a startup.

    Turner

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  10. Hailee Barbarits

    Dani,
    I am glad you liked this chapter, as I found it incredibly boring! I think as both an entrepreneur and an investor, I would like to offer/have preferred common stock. I want to pay back the investor as an entrepreneur, and as an investor, I want to get my money back first. This may be business, but essentially, as an entrepreneur, I would be borrowing money from someone. I feel as if it would be no different than asking a friend/family member for $100 and feeling the need to pay it back as soon as $100 comes back up.

    Like

  11. Angelina Murray

    I am happy you liked the chapter. I had a hard time understanding some of the parts. I like that you break the most common methods down into simpler terms. Its seems as though you know what you are talking when it comes to investing. I also liked that you even added the rules at the bottom. I like your layout of your blog as well. Great post. I enjoyed reading it!

    Like

  12. projectideaevolution

    Dani,

    This is a great though-provoking post. The more I think about structuring, the more I think it all about perspective and the goals of the investor and the entrepreneur. As long as those goals align, the structuring aspect could be negotiated.

    Jennifer

    Like

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