Angel Investors II: Structuring the Angel Investment
This is part 2 of a 2 part series on receiving angel investments. Once your company has decided to take on an angel investor, you have a couple of decisions to make.
Convertible Notes vs. Equity Purchase: What is right for you?
As discussed above, angel investors may be flexible in how the financing is structured. Two possible approaches a financing could take are convertible notes and equity purchase. The differences between the two are discussed below:
Convertible notes act like traditional notes, but grant the investor the option to convert the balance of the note into equity instead of seeking repayment at the choosing of the investor, or automatically upon a specified date. You do not need to value the company in order to execute a convertible note. These notes are also easier to produce than full-financing documents, resulting in lower legal costs. Convertible notes will often contain a provision specifying that the note will automatically convert into equity in the event of a qualified financing, usually defined to be the closing of a set round of a specific dollar amount or higher. In that case, the note will convert to whatever type of equity is issued in that round of financing.
In this type of deal, the investor will purchase equity in the company in exchange for cash. The investors and entrepreneurs will agree on a set price that the investors will pay for each share of the company. This is how many financing deals are structured, and may be the preferred format for an angel investor.
One thing to keep in mind when structuring an equity deal is that convertible notes previously issued by the company may have an automatic conversion provision that will be triggered by this new round of financing. If that is the case, the value of these notes and the corresponding stock that will be issued in exchange for them must be taken into account when valuing the company. The two different methods traditionally followed in the industry to account for the convertible notes when setting the price of the new round are:
a. Convertible notes as part of the pre-money. One choice is to include the value of the convertible notes in the pre-money valuation of the company. This is complicated, though, because the value of the convertible notes is determined by the price per share at which they will convert. The price-per-share is set by the new round of financing, which under this method is determined based on the value of the convertible notes. This method will rely on an iterative excel calculation to determine the price-per-share for both the convertible notes and the newly purchased shares. One way to estimate this calculation is to simply subtract the amount of convertible debt (perhaps factoring in the discount or cap to calculate the purchasing power of the convertible debt) from the negotiated pre-money valuation. Generally, this will result in a lower price and so will benefit the investors.
b. Convertible notes as part of the post-money. Another option is to factor the convertible notes as part of the new money coming into the company. The investors and the company will decide on a price-per-share for the round based on a pre-money valuation of the company that does not include the convertible notes. This will generally result in a higher price per share, benefiting the company.
Compliance with Securities Laws
The SEC considers both a sale of equity or a convertible note as a sale of a security. As such, you will want to make sure that you meet one of the SEC’s private offering exemptions and that you file the necessary forms with the SEC and with the state in which the investor(s) reside. You will want to research the requirements for your specific financing directly on the SEC website and on state websites. Do not rely on general advice. Most angel investors will be accredited investors, making the exemption under Rule 506 available to you if they are. Generally, you will need to file a Form D with the SEC within 15 days after the sale is made. You may also need to make a notice filing and pay a fee to the state in which the investor resides within that time frame. Note that if you are receiving money from an angel syndicate but each individual investor will be writing a check you must comply with each investor’s home state filing requirements. Be sure to check out www.sec.gov and each state’s secretary of state website and http://www.NASAA.org to ensure that you comply with all regulations. Also, note that the SEC requires that Form D be filed electronically. This will require access to the EDGAR database and may take multiple days to set up. Be sure to look into the securities filings early so that you do not miss the deadline.
In general, angel investors may be a good match for your company’s financing needs. Before agreeing to bring in an angel investor, though, be sure to assess whether this is the best fit for your company. Once you’ve made the decision to follow through with the financing, consider how to best structure deal to suit your company’s needs and be diligent in complying with necessary federal and state regulations.
Read part 1 of this 2 part series: Angel Investors I: Should You Take Money From an Angel?