June 7, 2011
Lerch, Early & Brewer's Legal Update
For many start-up companies, angel investors continue to fill a void between the small amounts of initial funding that may be available from friends and family members, and subsequent, larger rounds of financing available from venture capital firms. Angels are frequently wealthy individuals, many of whom have successfully built one or more companies, who invest their personal funds. Angels either invest alone or as part of an organized consortium. There is also the emergence of super-angels, institutional angels and micro-VCs who invest third-party capital in smaller amounts.
According to the Center for Venture Research, University of New Hampshire and PWC MoneyTree, angel investors provided the majority of funding for start-ups in 2009 in the United States. Approximately 259,500 angels invested approximately $17.6 billion in financing for approximately 57,000 separate deals.
Convertible Note with a Cap
One current approach to the legal structuring of an angel financing that has gained popularity is a “convertible note with a cap.”
What is a Convertible Note?
A convertible note is a debt instrument that usually converts automatically, or at the option of the holder, into a company’s preferred stock at the time the company closes on its first preferred round of financing that meets a minimum dollar threshold.
What Are the Benefits of a Convertible Note Structure?
A convertible note is a relatively simple legal structure, and enables a lower transaction cost. Prior to conversion, as a debt instrument, the convertible note provides the angel investor with certain advantages over holders of common shares, with the main one being its priority status with respect to the assets of the company. Furthermore, a convertible note bypasses the need for the parties to agree on the current value of the company, a difficult task for an early stage start-up company.
Why the “Cap”?
The cap ensures that if the issuing company is wildly successful (i.e., there is a significant jump in the value of the company for the first preferred round and a considerable amount of capital is raised) the angel investors still will own a material percentage of the company. The angel investor will usually have the option to convert at either (i) a negotiated discount (i.e., 20%) to the first preferred round or (ii) the agreed-upon valuation cap. The angel investor thereby is compensated for investing during a period when market risk, execution risk, technology/product risk and financing risk are usually the highest.
Example: The Use of the Cap
Assume a company with 1 million shares of common stock outstanding issued a $500,000 convertible note, with a conversion discount of 20% and a conversion cap of $6 million. The start-up was extremely successful, and was able to raise $15 million at a pre-money valuation of $45 million in its first preferred round of financing. With the $6 million cap on the valuation, the angel investor would own 83,333 shares or 5.9% of the company post investment. If no cap were in place, the angel investor would only own 11,111 shares or 0.8% of the company post investment. (In this example, if the angel investor used the conversion discount, it would have invested based on a $36 million value, and would own 13,889 shares or 1.0% of the company post investment).
Conclusion
Traditionally, the seed round of funding often was executed with common stock or convertible notes without a cap. Deal structures now have evolved to include convertible notes with a cap. As the role played by angel investors (individuals, groups, funds) continues to expand and evolve and the cost of launching a new company continues to drop, we can expect the deal structures demanded by angel investors and entrepreneurs to evolve with this rapidly changing market.
The attorneys in the Business & Tax practice at Lerch, Early & Brewer in Bethesda, Maryland provide a range of services for emerging businesses, including formation of entities; structuring employee stock option and restricted stock plans, and other compensation arrangements; corporate governance; and strategic partnerships and joint ventures. For more information about how to review a term sheet, formation of entities; structuring employee stock option and restricted stock plans, and other compensation arrangements; corporate governance; and strategic partnerships and joint ventures. For more information, contact Lerch Early's Business & Tax department at (301) 986-1300 or visit the Business & Tax practice page.
