How Angel Investors Can Protect Their Rights in Startup Deals
Every influential company began as a startup, and many of those startups wouldn’t be where they are today if not for the help of angel investors. If you’re one of these investors, you’re playing a vital role in shaping the next generation of businesses.
Many angel investors take a somewhat hands-off approach after putting money into a startup. However, if you want to protect your investment and maximize your chances of a significant return, it’s important to understand how angel investors protect their rights in startup deals.
Learn more about preemptive rights in angel investments and how you can take steps to protect yourself and your capital.
Understanding Angel Investor Protections in Startup Deals
When a new company accepts investment capital from private investors, it typically must provide assurances that it will respect and preserve angel investors’ rights. Startup deals can be complicated, and the exact strategies used to protect those rights can vary by industry, company size, and each investor’s preferences.
However, many angel investors rely on one or more of these common strategies to protect themselves and their money:
- Requiring representation on the company’s board as a condition of investment
- Including protective provisions in the deal (like those granting investors veto power over major decisions)
- Requiring that they be paid back first in the event of company liquidation
- Requiring anti-dilution provisions to protect investors’ equity
In most cases, company founders and angel investors must negotiate and come to an agreement that serves both of their interests. Angel investors want to minimize their chances of losing money, while founders want to avoid overly strict provisions that could negatively impact the way they run the business.
Structuring Investments to Safeguard Equity and Influence
When structuring startup deals, angel investors usually prioritize protecting two things:
- Equity: Their ownership percentage of the company
- Influence: Their ability to retain control (at least in part) of the company’s direction
When it comes to protecting their rights during an investment, angel investors have no shortage of strategies. However, there are three particularly common tools and strategies for creating investment structures that protect investor interests:
- Requiring board seats
- Requiring information rights
- Using founder restrictions
Here’s a closer look at these strategies for protecting investor rights and what each one may look like in practice.
Requiring Board Seats
Board representation rights for angel investors aren’t unusual, especially when those investors are making significant contributions. Investment agreements that allow investors to take board seats may or may not limit the investors’ term on the board.
Many angel investors aren’t interested in remaining on a company’s board of directors indefinitely. They’re usually more concerned about guiding early-stage startups. Once the company becomes stable and profitable, early investors often back off.
Whether you should make board seats a condition of investment or not depends on how much equity you have in the company.
Requiring Information Rights
If you’re contributing startup financing but haven’t given enough to justify a board seat, you might want to make information rights a condition of your investment. This just means that the company is obligated to regularly share financial and management data with you and other shareholders.
Many businesses share this data quarterly. However, if the company is new and unproven, you might consider asking for more frequent updates.
Using Founder Restrictions
Many new startups heavily rely on key employees. They often rely on their founders most of all. To help shield their financial interests, some angel investors insist on something called “founder vesting.” This is when a founder receives an immediate grant of shares in the company, but those shares vest gradually over several years.
Founder vesting incentivizes founders to remain with the company for a set period. Without founder vesting, the company’s founder could pull out early and take their entire ownership stake with them.
Protective Clauses Every Angel Should Consider
Investor-protection clauses in startup deals help incentivize investment by lowering risk. Every founder and angel investor should be familiar with angel investment term-sheet protections like the following:
Pro-Rata Rights
Pro-rata rights in angel investing give early, major investors the opportunity to provide additional financing in future funding rounds. They don’t create any obligation for the majority shareholders and other major investors to participate in future funding.
Negotiating pro-rata rights is almost always worth the effort. If it becomes clear that the startup is going to be successful, you may increase your total investment in future funding rounds.
Anti-Dilution Protections
Once startup growth takes off and a company starts attracting new investors, it begins to issue new stock. As the number of total available shares increases, the equity ownership of existing investors decreases. Early investors have the same number of shares as before, but the value of those shares is diluted.
This is why an anti-dilution clause for angel investors comes standard in almost every initial investment agreement. Anti-dilution protections prevent angel investors’ shares from losing value as more stock is created.
Liquidation Preferences
Ideally, angel investment serves as a catalyst to help promising companies reach their potential. But what happens if the company’s business plan fails?
If the startup you’ve invested in goes under, there’s a good chance it will be liquidated, and those funds will be used to repay major investors. In many cases, there isn’t enough money to repay everyone in full.
For this reason, angel investors should seriously consider making liquidation preferences a condition for investing. This means that if the company fails and liquidates, you’ll be paid back first. Liquidation preferences for angel investors don’t guarantee that you’ll get your whole investment back, but they’re a powerful safeguard against risk.
Legal Documentation and Compliance Essentials
As an investor, you’ve made protecting your capital a primary concern. However, legal protections for angel investors themselves are also important. One of the key laws protecting your interests as an investor is the Securities Act of 1933. This law imposes transparency and disclosure requirements on companies to protect investors from fraud.
There are many legal considerations to weigh before investing, and it’s always a good idea to consult an experienced legal team before you invest. Angel investing is a complex transaction that often involves several key legal documents.
Accredited Investor Questionnaires
In many cases, early-stage startups aren’t required to register their offerings with the Securities and Exchange Commission (SEC). However, if they don’t register with the SEC, they may typically sell securities only to accredited investors.
Accredited investors are those who meet specific criteria for wealth, income, and/or financial sophistication. The startup will likely ask you to fill out a questionnaire and certify that you’re accredited before you can invest.
Term Sheets
Term sheets are effectively summaries of proposed investment deals. Startups often use them to connect with potential investors, but they aren’t legally binding. However, legal professionals typically use them as a guide when drafting the actual contract for the deal.
Investor Rights Agreement
Shareholder agreements for startup investors are a core part of angel investing. An investor rights agreement (also called a registration rights agreement) outlines your rights as an angel investor. Usually, these agreements allow you to register your stock with the SEC as part of an initial public offering, so you can trade it freely.
Voting Agreement
A voting agreement outlines how majority and minority shareholders will vote when making decisions that impact the company.
Pre- and Post-Investment Due Diligence
All major investors understand the importance of due diligence before investing in a business. However, angel investors face unique challenges in this area compared to other investors.
Why? These investors are typically among the first contributors to a business. The company’s operations may just be getting started, so there are limited data points to consider. More often than not, angel investors invest based on a belief in the company’s future rather than on demonstrated performance.
If you’re like many angel investors, you rely on your gut feeling about the startup (at least in part) when deciding whether to make an investment deal. However, we generally suggest asking yourself the following questions about a proposed investment:
- What are the key risks this company faces? Am I prepared to accept those risks?
- What is my assessment of the company’s management?
- How likely is the company to retain key talent going forward?
- Does the company have a sound financial model? Are near-term milestones achievable?
- Is there a reliable base of potential customers who will see the company’s product as essential?
- Does the company have breakthrough technology? How can one tell?
- How would I assess the strength of the company’s current intellectual property?
- Is the company’s proposed strategy easily scalable?
- What kind of competitive environment is the company stepping into? How will that environment change over the next several years?
- What legal challenges are likely to apply to early-stage companies like this one?
- Are my goals for the company in alignment with those of the founders?
If you’re part of a collective of multiple investors or larger investing bodies like venture capital firms, you’ll be able to discuss these questions with other major investors. Taking your time and thinking critically during the due diligence process will help you make a sound decision.
Negotiation Strategies to Maximize Investor Protections
Angel and venture capital investments are a balancing act between founders and investors. It can take some time to reach an investment agreement that both are happy with. These tips may help you streamline your negotiations while reaching an agreement that’s fair to all:
Be Clear About Investment Criteria
To save both your time and that of the company founder, you should be transparent about your basic investment criteria. Once the founder has a sense of what you’re looking for, they can decide whether to move forward.
Know Your Non-Negotiables
Successful negotiation requires flexibility, but you should also have decided on your non-negotiables before you start. Whether it’s a specific equity percentage, pro-rata rights, or something else, it’s imperative to be clear about your boundaries and know how to articulate them.
Open a Dialogue
Negotiation isn’t just about communicating your terms. You must also take time to really listen to the founder. What are their funding needs right now? What challenges are they facing? How will an infusion of capital help overcome them?
Work With an Attorney
Even if you’re a skilled negotiator on your own, having the support of a qualified attorney is highly advisable. Your lawyer can help you tackle the many challenges of negotiation, and once you’ve reached an agreement, they can draft the necessary documents.
Before You Invest in a Startup, Call Us
Understanding how angel investors protect their rights is vital for any current or aspiring angel investor. However, knowing about protective provisions and putting them into practice are two different things. If you want to develop a personalized strategy to shield your rights in a startup deal, having experienced legal representation is essential.
The accomplished team at Weberman Business Law P.C. provides valuable guidance to startups, established businesses, and investors. We focus exclusively on business law and aim to help companies across all sectors overcome legal hurdles and achieve business success.
If you’re interested in angel-investor legal services or are looking for guidance through the investment process, contact us today.