QUESTIONS BOARD MEMBERS SHOULD ASK ABOUT ANGEL FINANCING STRATEGIES
Angel financing is often the first round of financing for
early-stage companies. Angels are typically wealthy individuals who
allocate a small part of their net worth to investments in high risk/high
reward early stage businesses or businesses which are more mature but have
smaller capital needs than more traditional venture capital deals.
For the entrepreneur, angel financing often provides the critical first
funds needed to attract key employees and to develop a technology or a
product to the point of commercialization or to a stage where more
significant venture capital funding becomes available. Angels operate in a
number of ways, sometimes through groups of pooled funds or individually.
Angels are even available now through Internet links and networks.
Typically, angel investors are those individuals who know the
entrepreneur from a family or business relationship or understand the
business, either through the angels own business experience or
through prior investments. Most angels as a group invest up to $1,000,000
(although often less).
Over the past several years, liberalization of certain securities laws
and the stock market boom have resulted in increasing levels of angel
financing. Under Rule 504 of Regulation D of the federal securities laws,
investors purchasing up to the first $1,000,000 in stock in a private
company in a 12 month period may typically resell their shares following
an IPO without regard to the holding periods imposed under Rule 144. In
the past, investors had to wait two years or more following their
investment before they could resell under Rule 144.
An entrepreneur considering raising equity through an angel financing
should consider the following in structuring a deal with angels:
Type of Securities - Angels often purchase plain
vanilla common stock. Some angels ask for preferred stock, with
certain rights and liquidation preferences over the common stock. Some
even ask for convertible debt, or redeemable preferred stock, which
provides a clearer exit strategy for the investor but also places the
company at the risk of repaying the investment plus interest. If the
angel asks for preferred stock or convertible debt, the entrepreneur
will need to consider the ability to repay the investment as well as the
possible impact of the investment in future financing rounds. For
example, a venture capital source will likely not want to use its
investment to bail out prior investors.
Rights of First Refusal - Some angels ask for a right of
first refusal (ROFR) to participate in the next round of
financing. At first blush, this makes perfect sense as the entrepreneur
will want to reward the investors who took the most risk. At the same
time, a ROFR may be cumbersome if the next round of investors wants to
control the participants in that round or to satisfy the investment
minimums of those participants.
Board of Director Representation - Angels often serve on the
Board of Directors following an investment. As the company raises future
rounds of financing, the issue arises as to how long the angel should
continue to have the right to be elected to the Board. One alternative
is to have the board right disappear once the Company raises a certain
amount of equity financing or if the angels ownership percentage
falls below a certain level.
Negative Covenants - In order to protect their investment,
angels often ask the Company to agree to not take certain actions
without the angel investors approval. These include selling all or
substantially all of the companys assets, issuing additional stock
to existing management, selling stock below prices paid by the investors
or creating classes of stock with liquidation preferences or other
rights senior to the angels class of security. Angels may also ask
for price protection, that is anti-dilution provisions that will result
in their receiving more stock should the Company issue stock at a lower
price than that paid by the angels. As with the ROFR and Board
representation, there are points at which these covenants should
disappear so as not to unduly limit the companys right to raise
capital going forward or to unduly restrict managements operations
of the company.
Structured correctly, angel financing can provide not only needed
capital but momentum to an early stage venture, allowing the company to
grow and raise additional equity to propel its growth into the future. As
in all stages of financing, entrepreneurs should work with advisors who
have the experience necessary to assist the entrepreneur regarding the mix
of contract rights and restrictions appropriate to the particular
Neil H. Aronson, Partner in the Technology Group at Mintz, Levin, Cohn,
Ferris, Glovsky and Popeo, P.C. Boston, MA tel. 617/348-1809