The 7 fundamentals of early stage investing – “Structuring”

You will be asked “how are you structuring the deal?”.  What does this mean?

Angels are asking:

  1. What are their investment terms? What type of financing will they provide equity or debit?  Will the investors get their cash back before the company does?  And, will the angels have the right to invest in future business opportunities with you?
  2. What role will the angels play in your company after they invest? Will they be silent investors, active ones or something in between?  Describe their duties and responsibilities.

Angel investment structures vary, but they typically invest in one of three types of securities:  Common Shares, Convertible preferred shares, and Convertible debt.  Wait – What?  What does this mean?  Let’s define some of these and see what you need to know about each.

Common Shares

Are residual value shares of the same class issued to a company’s founders.  This is the simplest but provides few safeguards to the investor.

Convertible Preferred Shares

Is more complicated but can benefit the investor to a greater degree.  Convertible notes allow no negotiation on price but offers angels the most protection.  It’s all negotiable, but the time to negotiate is before the term sheet gets signed.

Convertible Debt

Angel investors often invest through convertible debt.  This involves the investors loaning money to the company, with the loan amount being convertible into equity shares of the startup.

The advantage of this structure is that the parties involved can defer fixing a valuation on the enterprise until future financing is set.  When the financing is done, the debt converts into equity shares at the purchase price, sometimes with a discount to reward the angel for investing early.

Make sure you do your homework and have a plan for this step of the angel investments.  You want to be prepared on every level!

David Amis-Howard Stevenson (2001). Winning angels: the seven fundamentals of early-stage investing. Pearson Education.

  • We addressed the same things in our blog. I was fascinated by this chapter and the three types of structures. I prefer the convertible debt as it allows the investor to get all or some of their money back. I feel this would help if one wanted to bring an additional idea to them in the future. Great work.
    Nicole

  • Christina,

    Nice overview of the structuring topic! I think it’s amazing how many different choices we have when it comes to investing. Not only are there the big structures like you mentioned (common stock, preferred stock, etc), but just think of the tons and tons of terms that can be applied in an effort to maximize return and minimize loss. It’s great to know those options exist.

    Austin

  • I am still weary of convertible debt, from an investor standpoint, but I do see the value the Nicole mentions in her comment. It is reassuring to know that you will be able to get some, or all, of your money back if the business goes south. But what if the company files for bankruptcy because they have no money to give back. I’d prefer to have shares of the company and take the value of my equity than to risk nothing at all.

  • Hi Christina,
    I like your break down of the investment structures and how you defined them. If you were an investor what structure would you choose?

    thanks for sharing

  • I think I remain the fan of preferred stock. It might take a little longer to set up, but I like the idea of mitigating my downside as much as possible. I think if I’m going to invest, I shouldn’t invest more than I can afford to lose. I’m okay with the risk, I just would want to minimize if I could.

    What about you? What would be your preferred method?

    • Hey David! Thanks for the comment! This is a tough one for me. I’m actually not sure which option I would go with. I have a lot more homework/research to do for sure!

  • Preferred stock still has the most attractive pay-off. It gives the investor a greater upside since negotiations occur before the term sheet is hammered out. An attractive element for the preferred stock is pay-out first! Priority, Priority…so it’s worth the extra time to negotiate.

    • I agree, it’s worth time to negotiate. You don’t want to miss out on anything, especially when this is your business. Thanks for the comment!

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