Structuring (4th Fundamental of Early-Stage Investing)

While some fundamentals are open to interpretation, early-stage structuring seems to have a more specific foundation. The principles behind structuring early-stage investment deals are to keep it simple, comprehensive, yet unrestrictive for future funding rounds. Regardless of the structure employed, it is important to consider its implications on future funding rounds. A simpler structure will speed up negotiations as the venture transitions from the angel round to VC funding. Below you will find some structuring highlights and links to helpful resources.

Common Structures

There are three (3) primary ways to structure an investment deal: Common Stock, Preferred Convertible, and Convertible Notes. While detailed discussions about each structure are beyond the scope of this post, below are some useful definitions from the Global Impact Investing Network (GIIN) and the Angel Capital Education Foundation (ACEF).  

Common Stock- Is subordinated to (1) all government claims or taxes, (2) all regulated employee claims (e.g., pension obligations), (3) all trade debt (accounts payable), (4) all bank debt, and (5) all forms of preferred stock (GIIN, n.d.)

Preferred Convertible- Stockholders have priority in getting their invested capital back, along with any unpaid dividends, before the common stockholders receive any distributions. Convertible preferred shares are able to be converted to common shares at a predefined conversion rate (ACEF, 2007).

Convertible Note- Convertible Notes are debt instruments and are preferred by some angel investors and entrepreneurs. Typically convertible notes contain the right to convert into equity upon the occurrence or non-occurrence of specified events (ACEF, 2007).

The following links provide extensive information and examples of these structures listed above.

Global Impact Investing Network (GIIN)

Angel Capital Education Foundation (ACEF)

Future Rounds, VCs & Exit Strategies

Startups go through a development process that starts with the entrepreneur(s), moves on to angel investors, and then goes to VCs. These three players overlap at some point or another in their quest for the greater good of the business and their own investments. In order to enhance such development and ensure smooth transitions, it is essential to consider the crossroads of the structures described above, deal terms, and exit strategies. 

Most angel investors believe that early-stage investment structures must be simple, non-restrictive to future deals, and based on a reasonable valuation. David Amis and Howard Stevenson suggest that “Preparing for and thinking about future rounds is critical when choosing a structure and setting the terms. A bad deal structure can damage the company’s ability to recruit additional investors, or even to sell at an attractive price” (p. 198, 2001). The best way to prevent a bad deal structure is to review carefully the proposed terms. Proposed terms are formal, yet non-binding. They will guide negotiations until the final terms are established. (Click here for a comprehensive list of deal terms).

Emma McGowan from Startups.com:

“A good term sheet aligns the interests of the investors and the founders, because that’s better for everyone involved (and the company) in the long run” (Startups.com, 2018).

Now, what exactly is “the long run”?

The long run is a profitable exit! Everyone comes to an investment opportunity to create value and wealth, which should translate into profits. Therefore, consideration and discussions of a profitable exit need to be front and center. Once an exit strategy has been established, it must be integrated into the terms of the deal to ensure there are mechanisms in place to execute such exit.

This short introduction to Structuring early-stage investment deals is meant to provide a foundation and a starting point for additional research. Helpful links have been added to supplement such research and hopefully spark additional inquiries. Feel free to comment below with thoughts, comments, additional resources, or other relevant input.

 References

Amis, D. & Stevenson, H. (2001). Winning angels: the 7 fundamentals of early stage investing. London: Pearson Education Limited 2001.

The Startups Team. (2015, April, 2). How to get angel investor agreements using win-win deal structures. Startups.com. Retrieved from  https://www.startups.com/library/expert-advice/angel-investment-deal-structures

McGowan, E. (2018). Term sheets: what you need to know. Startups .com. Retrieved from https://www.startups.com/library/expert-advice/term-sheets?__hstc=219066822.b24df60d5cf9eac4bbb4f6b933b1916a.1560810024438.1560810024438.1560814325571.2&__hssc=219066822.1.1560814325571&__hsfp=1059072679

Koss, A. (2007). Best practice guidance for angel groups – deal structure and negotiation. Angel Capital Education Foundation. New York University. Retrieved from https://www.angelcapitalassociation.org/data/Documents/Resources/AngelCapitalEducation/ACEF_BEST_PRACTICES_Deal_Structuring.pdf

Global Impact Investing Network. (n.d.). A guide for impact investment fund managers: a step-by-step resource to creating and managing a private equity impact fund. Retrieved from https://thegiin.org/structuring-the-deal