Mark Rathbone, Brabners LLP, Head of Corporate in Liverpool, discusses what to expect when becoming an angel investor and what to consider when entering into a possible deal, in the first of a series of articles.
It has long been our view that a strong sophisticated angel community is essential to a growing entrepreneurial economy fit for tomorrow. Angels are a key element of the funding matrix for businesses. A good angel transaction delivers early stage funding with significant added value.
Angel investing at best covers two prime functions: it marries funding requirements of early stage businesses to a series of funding rounds and so needs angels with sufficient funding capacity to meet more than one round of funding; in addition, it marries the knowledge, experience, network and entrepreneurial skills of the angels to the needs of the early stage business, enhancing its growth potential and better enabling it to solve issues quickly.
Given the massive changes in technology and the world that it is creating, angels who are willing to invest in tech businesses, who understand the technology and the market into which it is to be sold, are a rare breed. Many early stage tech businesses are pre revenue, with technology not yet proven in a fast changing market. Understanding the risks in the technology and the market is difficult. It is therefore of paramount importance that transactional risk, the governance risk in business and shareholder relations and the risk in illiquidity of the investment, is fully understood and minimised or managed to the fullest extent.
The bare bones of a proposed deal should be available for consideration before a lot of time is spent on due diligence and negotiating legal documentation. Initially some work will be involved in getting to know the management team to get a feel for whether you can work with them. In addition, a good understanding of what the technology’s capability is and what market it is anticipated to be attractive to. Understanding latest financial performance and immediate prospects is also hugely important at this point. Having got to this stage it is important to map out with the founder what the deal is.
To understand the deal as a whole, there are a few constituent parts:
The financial performance, immediate prospects and business plan forecasts will inform the valuation that might be placed on the business as a whole. The valuations placed in any previous funding rounds might assist, but should not be taken as gospel. There is no fixed valuation methodology, though there are many gurus who make their own methodology freely available on the internet. Whatever value is placed on the business in these negotiations will be what is used to derive the price for your investment, which will be the same percentage of that value as the percentage of the shares in the business you subscribe for. You should make sure that the value includes the cash being invested by you and others in this funding round, as that goes straight to the balance sheet.
The various shareholdings
The other investors in the business, in this round and those already invested, needs to be understood. A cap table should be prepared, showing the investor shareholdings before your investment, after your investment and showing further expected dilutions through exercise of share options. Share options might be already held by employees, including the existing managers. Equally, share options may be proposed to be issued to employees and the deal may give consent to the grant of those options as a percentage of share capital. The cap table will provide an understanding of the historic funding rounds, it will illustrate the percentage of the equity that you are to purchase and will show how that equity is expected to be diluted at exit. What it will not do is show you what further funding rounds might do to dilute your equity percentage further.
Equity vs loan notes
Is all of your investment to be made in equity, or are you acquiring loan notes? If you are looking to benefit from Enterprise Incentive Scheme (EIS) status for your investment and the reliefs then available, this will only be available in relation to your investment in equity, so it may be ill-advised to invest by way of loans. If EIS is not available, you may want more of your investment to be by way of loan, but that will depend on the valuation and the other investors (both present and historic).
It is important to understand where the power is in the business and amongst the shareholders. Who are the managers or founders? Are they to control the Board or the shareholders? One shareholder or a group of shareholders may hold the every day balance of control. Do any of the shareholders have ultimate control in certain circumstances, such as a right to swamp the board if the business is in financial difficulty? You should note also whether any shareholders have debt in the business and so have an ability to control the business by calling in their funds, or exercising or enforcing any security they have over the assets of the business?
Shares in a private company are not liquid assets. Should you or any group of shareholders be seeking a right to force an exit after a certain amount of time?
Another issue that must be considered is the next expected funding round. It is unusual that an angel investment will be the last fund raise of a business. Any later fund raise will impact on the equity percentages of the shareholders. An ability to participate in later funding rounds should be a key consideration of any angel.
It is important that all of these matters are considered by the angel at this early stage and discussed openly with the managers/founder and the other investors. A term sheet should be prepared, setting out the key terms required and giving some exclusivity to the angels. This then gives time for due diligence and key legal documentation to be drafted and negotiated.
As part of our partnership with Tech North on the Angel Network, Brabners LLP will be covering all stages of investing in articles over the coming months, aimed at assisting business angels to comprehend and manage risk in transactions. The intention is to equip angels to better understand the deals proposed to them, to better enable them to negotiate those deals, as well as to evaluate the risks against rewards.
Look out for our next article considering some of the key provisions you would expect to see in Heads of Terms and considering how you manage risk on the way into the investment.