Venture Capitalists: They're No Angels

Joseph W. Bartlett, Special Counsel, McCarter & English, LLP

Although angels invest at a lower price, VCs usually ask for and get better terms for their money. Why don't angels do the same? See what terms VC's are actually using in their deals.

Angel investor. Venture capitalist. Many investors would like to be one or both. Yet few know the distinction between the two–or which is more advantageous.

Angel investors are among the first investors in a startup and put up their money when the risks are higher. As a result, they have the advantage of coming into the company at a lower price–maybe half of what VCs will pay for the same amount of stock.

In addition, after the first venture-capital round closes (called the Series A), VCs generally own something less than 50 percent of the company for a number of technical reasons.

Interestingly, however, VCs still have an advantage over angels. The reason? They ask for and usually receive better terms.

Clipped Wings

As minority investors in a closely held corporation, angels' rights are typically minimal and limited to those rights extended by the corporation law of the company's state, as well as notions of fiduciary duty from the board of directors and controlling shareholders. Angels can vote in elections to the board and extraordinary corporate events, such as a sale of the company's assets, but these rights are largely ephemeral if the company is solidly in control of the founders.

In an economic sense, the only real right an angel has is to be a nuisance. But in reality, angels must suffer a significant outlay of capital, threaten litigation and/or expend their time and energy to force their hand. And the rewards are often unclear.

VC investors, on the other hand, typically demand and receive special rights. Some sit on the board, while others may get so-called visitation rights, allowing them to attend board meetings but not formally vote. Since decisions tend to be made by consensus, a good negotiator or intimidator can make this visitation right quite valuable.

Veto rights, also known as "negative covenants," may also be granted to VCs. While founders may own a majority of the stock and occupy a majority of the board seats, VCs often have the ability to say "no" to things such as significant capital expenditures or the issuance of new equity securities.

Preferred Stock

The major distinction, however, between VCs and angels is that VCs buy preferred stock, a security preferred in liquidation and ostensibly carrying a stated dividend rate, while angels typically own common stock. The stated dividend is rarely paid in early-stage finance but it does accrue and is an obligation of the issuer.

The preferred stock is convertible, meaning that upon an exit event like an initial public offering or company sale, the holder can convert from preferred to common status, and obtain the residual amounts available instead of getting his or her money back plus the accrued but unpaid dividends. Translation: more money for the VCs.

Assume, for example, that as a VC I pay $100 for a preferred stock convertible into 10 percent of the company, implying a post-money valuation of $1,000. If the company is sold for only $300, I retain the liquidation preference of $100 and (forgetting about accrued dividends) walk away with my original $100, or 33.33 percent of the proceeds; the angels and the founders get $200, or 66.6 percent of the proceeds.

But if the company is sold for $5,000, I convert and walk away with 10 percent, or $500, thus quintupling my money. Sometimes, in fact, the VCs get the $100 back first and then take 10 percent of the remainder (10 percent x $4,900 equals an additional $490). Angels, unfortunately, don't have the benefit of this option. They do fairly well, however, if the exit event goes well, but can be left out in the cold–either absolutely or relatively–if the exit price is disappointing.

Comparative Advantage

There's no legal reason angels couldn't ask for VC-type terms but they rarely do. Practical reasons vary, but are often attributed to the fact that the $50,000-average cost of lawyering the documents typical of a VC or Series A round is out of proportion to the amount of capital being raised in the angel round.

All things considered, VCs may have an unfair advantage over angels. But favorable terms never turn a bad deal good. The trick for any angel investor is to pick a winner. That winning investment can make the comparative disadvantage to the professional VCs seem insignificant.

Joseph W. Bartlett, Special Counsel,

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