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 angel’s 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 angel’s 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 company’s 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 angel’s 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 company’s right to raise capital going forward or to unduly restrict management’s 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 circumstances.

Neil H. Aronson, Partner in the Technology Group at Mintz, Levin, Cohn, Ferris, Glovsky and Popeo, P.C. Boston, MA tel. 617/348-1809

Questions

Return To Board Options Home Page