Neil Patel here – and welcome back.
Perhaps by now you’ve told a few people in your life that you’re getting into angel investing.
Let me guess what happened next:
A friend of a friend happens to be starting a company, and they think it would be a great opportunity for you to get your feet wet.
Seriously – this will start happening to you, if it hasn’t already.
More than one in ten people owns a business, and every business needs cash to grow.
The way I see it, these referrals are a great thing.
Many of them aren’t worth investing in. But don’t think of those meetings as annoying wastes of your time.
Deal flow is deal flow, and hearing more pitches won’t kill you.
In fact, it might help you refine your process for selecting winners.
Maybe you’ve heard one idea that sounds just crazy enough to work. You’re still thinking about it a few days later, so you decide to take the plunge.
This is where things can get confusing. When you write a check for an entrepreneur, what does that money buy you?
Let’s break down the 3 most common types of startup investments.
1) Convertible note (or convertible debt)
What is it? A convertible note is a security that will convert into shares of common stock at a later date. Because it is treated as debt, it accrues interest (usually at 5 to 8 percent annually).
Why do people use it? A convertible note is handy for early-stage companies because it doesn’t require a valuation to be agreed upon. In simple terms, you don’t need to worry yet about how much the company is worth. You’ll get a proportionate slice of equity later on, once the startup has grown to a more measurable size.
My take: Convertible notes work, but I avoid them when I can. Since there’s no set price for shares yet, you have no way of knowing what percent ownership you’ll end up with. If the company grows and the stock price is high when it’s time for your investment to convert, you end up with fewer shares for your dollar. Some provisions (like a valuation cap) can mitigate this, but not prevent it. You took a chance on this company. Why sign a deal that gives you a smaller slice of the pie if the business takes off?
2) Simple Agreement for Future Equity (SAFE)
What is it? Developed by startup accelerator Y Combinator, a SAFE is not a debt. It doesn’t accrue interest or have a maturity date. A SAFE is a legal agreement that grants investors the right to purchase equity at a later date.
Why do people use it? SAFEs are quick, cheap, and founder-friendly, since they don’t accrue interest or behave like debt. Again, no valuation is necessary, which saves a lot of time and legal fees. The only thing investors and entrepreneurs need to agree on is the valuation cap, or the maximum price investors will end up paying per share.
My take: They may work for slam-dunk startups with virtually no chance of failure, but I don’t trust SAFEs when it comes to most investments. A SAFE is not a debt, so if the company never makes it to a VC financing round, you’ll never even get to see your shares. Plus, kicking the valuation can too far down the road can lead to some surprises once the cap table is finally spelled out. You might not like how small a stake you end up with.
3) Investing in a priced round
What is it? In a priced round, everyone has agreed on a valuation for the company. That’s no small task (more on that here), but it’s important. You are buying a set number of shares at the price that corresponds to that valuation.
Why do people do it? It doesn’t get simpler than this. You know what the company is worth; you know how much each slice of the pie costs; and you buy the amount you want. Boom –you’re now a part owner of the company.
My take: Keep it simple, silly. Invest in a priced round whenever possible. Coming up with a valuation can be tricky, but at least you’ll know exactly how much of the company you’re buying. No waiting for conversions, no surprise price hikes… just equity.
There are benefits and drawbacks to each option. Signing on with a SAFE or a convertible note may let you get in on deals earlier than waiting for a priced round to happen.
Equity rounds take longer, but give investors more control over their shares.
No matter which option you choose, make sure you have a thorough understanding of what your place at the table means for your bottom line. If you can, have your own lawyer look everything over before you commit.
But don’t let a technicality keep you away from a life-changing deal. Terms won’t always be perfect, and that’s okay.
It all boils down to the valuation, or projected worth, of the business.
But how can you assign a value to a company with no assets, no customers, and no product?
Click here to get to the bottom of how valuation works (and how it doesn’t).
Until next time,