In this, Mark Rathbone, Brabners LLP, Head of Corporate in Liverpool’s second article on angel investing for the relatively uninitiated, he looks further at the risks to be considered and managed when investing, and the content to be expected in the Heads of Terms.
The portfolio approach
You will have been told, I hope, that the key to successful angel investing is building a portfolio of investments. This portfolio approach can be as simple as looking to make at least 5 to 7 investments in different companies. It can be made more complex by looking at type and sector of business, pre-revenue and post revenue. Finally, the portfolio approach can include different approaches to investment type, from equity to debt and the hybrids in between such as convertible loans. You will therefore need to consider how the investment you are looking at fits into your portfolio and how it helps to spread risk across your portfolio.
The management team is absolutely key to every successful investment. Replacing one, or all, of a management team at some stage on the journey is very risky, and will often only be undertaken when the investment is really at risk. At the outset you need to be sure that you can work with the management team and that they can work with you. Most importantly, you need to be really confident that the management team can work together and that they have complimentary skill sets. A good amount of time should be spent with the management team to understand what makes them tick and how harmonious they are.
Due Diligence and Warranties
Something in the business or business model will have sparked your interest. It’s important to investigate the business – do your due diligence. You need to make sure that the intellectual property that makes the business prospects so unique are owned by the company in which you are investing, that no other person has a right to a royalty payment in respect of it and that the company has the right to develop and exploit the intellectual property. You also need to be confident that the opportunity is unique. It’s important to do due diligence on the technology and on the market. Another key element is to ensure that the company does not have any holes in its balance sheet. What is its history, has there been a historic business activity that is nothing to do with the present opportunity? You need to be sure that there are no hidden holes in the balance sheet and therefore no litigation that can result in a liability and take up huge amounts of time. What assets does it own, do they provide some value comfort for you on investment and if so, have you checked out their ownership?
In the documentation you can get comfort on many of these matters through warranties, but if you are claiming under warranties, the investment has gone horribly wrong, so the due diligence that you undertake at the start is key. Look to work with the other angel investors, if you are not investing alone. Using their varied experience, a far more thorough job can be done on the due diligence. Having an angel who knows the technology or the market can be a real bonus.
Heads of Terms
If we now consider the Heads of Terms (Heads) and what’s included; this is the first document you will see, or will put together, that will set out clearly what is on offer for you.
If you are an early stage investor, at the friends and family stage, the Heads of Terms will be brief and it is not unlikely that the legal documentation that follows will be relatively brief also. This is often done to keep costs to a minimum. However, it is important to consider such Heads of Terms in the context of what could be on offer in a fuller set at a later stage. The later stage angel is likely to be participating with a more sophisticated document set, one that is capable of operating through a series of rounds of funding.
The Heads of Terms should include the basics on the investment you are making, for which class of shares, whether there is an equity/debt split. It would be sensible to ensure that it includes some detail as to who is investing in this series and through the cap table, you should have details of the other investors too. I would also recommend that details are included as to what use the funds are to be put to and particularly if there is any intention to use any funds to pay out an existing investor (not a good sign for an incoming investor).
The Heads will then include details of the different classes of shares and the rights as to income and capital, in so far as they are not all equal.
The Heads may also set out certain provisions relating to the issue and transfer of shares. Pre-emption rights (or rights of first refusal) may be specified in relation to new share issues. Such rights allow you to “follow your money” so as to avoid dilution on a future share issue. Bear in mind that early stage companies often go through several funding rounds, and it may not be advisable to make any investment if you cannot follow it with further funds. The Heads may also specify the restrictions on share transfers, such as a requirement for any shares to first be offered to existing shareholders or an absolute restriction on share transfers. You would expect Drag Along and Tag Along Rights to be included, the first allowing a certain percentage of shareholders to be able to drag the others into a sale of all of the shares to a third party, the latter ensuring that each shareholder can join into any sale of shares that results in a change of control.
As discussed above, you might expect some warranty protection to back up your due diligence. The Heads should consider who is providing the warranties – you would expect the management team and the company to provide them. It is likely also to include some limits on the liability of the managers, set at a level to keep them honest, but not at a level that keeps them awake all night worrying. The warranties might include a level of comfort that the management team backs its business plan.
The investors will want to see some protection against the management team leaving. This might involve some “Leaver” provisions that enable you to get the shares back off them, as well as non-compete obligations.
Finally, there should be some governance provisions included. These will include the make-up of the board, a board of directors capable of making decisions, but with appropriate representation and protection for the investors. Within this can include some rights to swamp the board if certain trigger events occur, but really such provisions are better kept for private equity deals. Included also will be the information obligations and a list of actions that the company cannot take without some level of investor consent.
The Heads of Terms should be signed by the parties, but will not be legally binding. It might also include an exclusivity period that enables the investors to complete their due diligence and prepare and negotiate the legal documentation.
In the next of our series of articles, we will take a more in depth look at due diligence and warranty protection.