I’ve learned a huge amount about angel investing over the last few months. It started with me sitting down with my lawyer and getting a brain dump of terms, term sheets, provisions of all sorts, talking about notes and preferred series: the list goes on and on. But it’s all theory until you get out there and try to invest in something yourself.
I told myself I would try to be a sophisticated investor, meaning that I would spend the time (and money) to get every deal reviewed by my lawyer and I would make best efforts to read everything. It was the only way I could understand everything, which was to experience it in real time.
When I started looking at deals, many things emerged. Here are some of them:
It’s the Wild West
There is no such thing as standard. All term sheets have similarities, but everything is different, sometimes subtly different. Every law firm has its own style and favored terms to present, and modify that by the entrepreneur or the venture fund and you get every kind of combination of terms you can think of. All I can say is that I’m glad to have my lawyer around to look at terms with an experienced eye, and I can only hope that over months (years?) I too can gain enough experience at looking at terms and their ramifications.
Law Firms Protect Their Clients
And that’s a good thing. The law firms that startups hire will produce documentation that is always company friendly. Which usually means that it’s not very friendly for the investor. The terms will inevitably have provisions that don’t protect the investor at all. This confounds the process because sophisticated investors will always push back and alter the terms. If there is pushback, then legal fees will mount, as the process of negotiation goes back and forth on the terms.
The downside is that entrepreneurs are typically new to the financing aspect. They don’t know enough to ask for more balanced terms when developing term sheets. They just take whatever the lawyer gives them.
I always push for balanced terms that favor neither investor nor company. In my limited experience, it has resulted in the fastest way docments get approved and signed with minimal fuss and cost.
Money Gives You the Lead Position
One thing I found out was that at the amounts I’m angel investing ($25K – $100K per investment), I am typically not the lead investor. That unfortunately means that I have little leverage to modify the terms; if I had put in more money, the entrepreneur is incentivized to negotiate with me and keep me happy in order to get my cash. If I am only putting in a small amount relative to others, or as a percentage of the total raise, then it is up to me to do my best in gracefully pushing for better terms.
Sophistication or Attention to Detail is Severely Lacking in Angel Rounds
During angel rounds, it is often the case that the entrepreneur went to their friends and family to get much of the money. These folks have cash, but almost always have no experience with terms and what is good and what is not. They rely solely on trust of their family/friend to not screw them when it comes to protecting their investment. When I arrive on the scene, it is often the case that a lot of the money has already been raised, and now we have a whole crew of people who have accepted the terms, albeit not fully understanding them, and now I have little leverage to ask for different terms because the entrepreneur would now have to go back to each investor and approve and sign off on changes. This will incur extra costs and perhaps even uncomfortable dialog between the entpreneur and family and friends (ie. you asking for my approval for better terms now…? why weren’t they in there when I signed the documents in the first place…?).
Big Experienced Angels Mess Up the Process for us Little Guys
Another issue I have encountered is the prevalence of angels in Silicon Valley with large sums of money. Throwing $50K, $100K, even $1MM into a startup during an angel round is done without attention to terms. How do I know they aren’t reading the terms? Because they invested in a company with investor un-friendly terms! And with the amount they put in, they could have easily negotiated changes in the terms.
Now that the entrepreneur has a big investor signed up, I show up with my investment and again I don’t have leverage to change terms, even if they favor the big investor, because the entrepreneur doesn’t want to go back and re-approve terms.
I asked around as to what these guys were doing. I found out that many have 40+ investments. With that many investments, it is impossible to keep their attention on any of them. And some of them are not experienced enough to know if a given company is good or not. Remember, this does not mean that they aren’t smart; it just means that sometimes you’re putting money in an industry that you may not have deep experience in. So they spread out their investments as much as possible in order to employ what I call the “Random Method of Investing”. Basically, this means you employ the theory that has been proven time and time again by venture funds, which is that for every 10 companies you invest in, about 6 will tank, 3 will do about even, and the last 1 will make back all that you lost and then some. Now you can see the reason for 40+ investments. It’s very much a passive investing operation.
My bet with David Shen Ventures, LLC is that I will improve that success ratio by being smart about the busineses I involve myself with, and I get involved with them to give them the benefit of my knowledge and experience. I am betting on an active investing operation and I hope to prove that this will be more lucrative than the passive route, as well as more fun.
Timing is Everything, But Not the Last Word
So far, in every investment I’ve done where I came in middle or towards the end of the round period, I generally have found that I lose leverage to change the terms. But I ask anyways. And it looks like dependent on the entrepreneur; often they will make best efforts to make changes or even make the change.
When I am at the beginning, I find that I can negotiate much better, even with my small amount going in. Over time, I hope to generate proof that going for funding with balanced terms results in lesser negotiation, less cost, and faster fund raising.
What’s the Future?
I think the route that others have taken may be the best. And that is to employ enough capital to be the lead investor in the round, angel or otherwise, and to be able to effect change in the terms because you are bringing so much cash to the table. Definitely, I am not there yet; my hope that is David Shen Ventures, LLC will be successful over time to be able to make succeedingly larger investments to the point where I can manipulate terms to the benefit of both investor and company.