How 2 Understand Investor Agreements: A Play in 3 Acts
For our final How 2 Tuesday of the academic year, the Blank Center invited law firm Morgan Lewis to explain the basics of angel and venture capital investor agreements. Morgan Lewis provides invaluable services to emerging businesses and is a generous sponsor of the Blank Center. The creative presentation was titled “Angel Financing: A Play in Three Acts,” and in it, two lawyers from the firm depicted a typical financing agreement between an entrepreneur and an investor.
Dinesh Melwani played the founder of a tech company that was ready for investment. Will Perkins acted as an angel investor. Before the play began, the audience was told that Dinesh’s and Will’s characters had been introduced by email through a mutual connection and that they had a long phone call in which Dinesh walked Will through the company’s pitch deck and business model. In Act I, they met at a local pub to discuss the terms for a seed investment.
The following phrases were used and are important to understand in the beginning stages of fundraising:
- Angel investor
- Angels invest relatively small amounts and use their personal money to do so
- Venture capitalist
- VCs typically manage money from a firm and invest larger amounts in early-stage companies
- Seed funding
- In this agreement, investors provide capital in exchange for an equity stake in the company
- The monetary worth of a company
- Capitalization table
- This table details and analyzes the “entrepreneurs’ and investors’ percentage of ownership, equity dilution, and value of equity in each round of investment”1
- Pre-money/post-money valuation
- A pre-money valuation is the value of the company prior to investment
- A post-money valuation is the company’s value after outside investment is added to its balance sheet
- Option plan
- Stock option plans are given to employees to incentivize them to boost the company’s stock price
- Vesting is a restriction placed on the stock option plan so that the shares are not all given to the employee immediately, ensuring a long-term commitment to the company
- If you have a co-founder, you should agree whether the company can buy back shares if one co-founder leaves early
The main takeaway from Act I were that the entrepreneur and investor should see eye to eye on each aspect of the agreement. Dinesh was seeking funding from various angel groups, which Will was open to. However, some investors are not willing to work with others. Communicate to ensure that everyone’s needs will be met by the arrangement. Additionally, each investor will likely pose a spectrum of requests before investment. If you are hoping to work with multiple, be prepared to address the needs of each individual investor.
Will and Dinesh explained that the investor has to believe that you and your partner are capable of executing your vision. Not only do they invest in your idea, but also the team itself. This negotiation process is similar to an audition because you need to convince the investor that you can really make your idea happen. Keep in mind that VCs will generally be more interested in digging into the numbers than angel investors because they are investing significant amounts of other peoples’ money.
In Act II, Dinesh and Will focused on negotiating the terms of the agreement. Again, it was important that both the company’s and the investors’ needs were met. Depending on the agreement, different documents are used. In the presentation, they used a SAFE, a simple agreement for future equity.
Here are some terms to know when aligning expectations:
- Convertible note
- A form of short term debt that converts into equity for the investor rather than repayment in the form of principle plus interest
- Preferred stock
- Stock that gives the holder a fixed dividend and whose payment is prioritized over common stock dividends
- Priced round
- “An offering and sale of newly-created stock in your company at an agreed-upon share price”2
- Preemptive rights
- A privilege extended to certain shareholders of a company that enables them to purchase additional shares before the shares become publicly sold
- Protective provisions
- These provisions, included in term sheets, give the majority shareholder of the company the ability to prevent certain company actions from being taken
Act III mainly focused on the execution of the term sheet. A common theme throughout the presentation was to ensure that the investor understands what you, the entrepreneur, will agree to. An example is whether the investor will receive a board seat or information rights. At this point, the entrepreneur and investor should also agree upon the timing, drafting, counsel, and expenses of the agreement.
After the final act had concluded, the lawyers emphasized the importance of working with accredited investors. The ideal investor will be happy to help you and will not be devastated if your business is not as successful as projected and does not provide high returns.
We hope you learned more about investor agreements from this session and that you enjoyed this How 2 Tuesday series! See you in the fall!