Business Insights: The Constellation, the Entrepreneur, and the Angel

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Among the many things entrepreneurs of all stripes should know, is your financing options! Here is a quick map of your business financing options, and a description of one approach to angel financing – “straight” debt in conjunction with an outright grant of equity – that results in a high degree of alignment between the entrepreneur and the angel.

  • If the business is very early in its life cycle, it’s a matter of boot-strapping (look for a subsequent post here, but until then this is a good priority list) and seed financing.
  • A next stage is angel financing, an example of which is the subject of this post.
  • Later there is venture capital.
  • When the business is no longer a start-up, private equity as well as bank financing (know your ratios!) and financing companies can become available.

These are the main points in the constellation of financing options:
10 Tips For Successful Bootstrappinghttp://www.entrepreneur.com/magazine/entrepreneur/2009/may/201102.html

Financing Your Greentech Startup: Tips for Raising Capital in the “Seed” Round
http://www.wagreentech.com/2011/05/financing-your-greentech-startup-tips.html
Financing Your Greentech Startup: Typical Terms in the “Seed” Roundhttp://www.wagreentech.com/2011/06/financing-your-greentech-startup.html
The VC Model: Square Peg for Round Hole When It Comes to Cleantech?http://www.wagreentech.com/2010/10/vc-model-square-peg-for-round-hole-when.html
Business Insights: Understanding the Basic Ratios to Securing Business Credithttp://springboard.resourcefulhr.com/?p=1457

Here, I want to outline an approach to angel financing I’ve recently seen in action – and highlight its salutary aspects. Under this approach, the angel does not take “convertible debt” in the startup, as is currently prevalent. Convertible debt is a loan, which can be converted to shares in a corporation (or membership units in a LLC) under terms and conditions set at the loan origination. There are many favorable attributes of convertible debt. Yet whether an angel investor’s singular metric is Return on Investment, or the angel has multiple objectives including ROI but also watering the tree of innovation, there are issues with convertible debt.

A different approach is for the angel to take “straight” debt on better than market terms from the viewpoint of the start-up (secured by what assets there are), and in consideration of the better than market loan, receive at the same time an outright grant of equity (shares or units). From the angel’s perspective, the “straight” debt maintains a favorable attribute of convertible debt, namely in the event the start-up fails, the debt holder is ahead of equity holders in the claims line. If being ahead in line doesn’t help the debt holder, at least the full amount of the bad debt is immediately deductible while capital losses are spread out over years.

Note that none of these favorable attributes of “straight” debt are at the expense of the start-up. So “straight debt” is also a good thing from the entrepreneur’s perspective – if the debt service can be safely handled. This necessitates that the angel be comfortable offering:

  • Deferred payment
  • Interest-only payments
  • A medium term rather than short
  • A lower interest rate than a start-up could otherwise obtain (frankly, it likely couldn’t get a loan in
    the first place)
  • Asking for a personal financial statement from the entrepreneur rather than a personal guarantee

The outright grant of equity to the angel in recognition of the better than market loan has several favorable attributes. From the angel’s perspective, the equity grant is the upside to the transaction. And wonderfully, it does not require the invariably painful discussions of valuation, because the equity grant is a “straight” percentage. The equity’s value all depends on what the entrepreneur makes of the startup (fortified with the working capital from the loan).

  • Using convertible debt can also avoid the painful discussion of valuation, by specifying that the principal amount of the loan can be converted (with a discount recognizing the greater risk taken by the angel) to a pro rata share of the valuation later agreed upon in a fundraising. But it’s standard practice for an angel taking convertible debt to ask for a cap on the valuation used for the debt conversion, in order to reduce the dilution of the angel’s hoped for equity to come. So convertible debt brings you right back to the pain of valuation, while a “straight” percentage equity grant does not.
  • An equity grant also doesn’t have the unpleasant realization event awaiting in convertible debt. This happens in cases where the value of the equity after conversion is greater than the debt (for example, due to a cap on the applicable valuation) and there is no cash or not enough to the convertible debt holder in the transaction to pay the taxes. True, the angel has a low basis in the equity grant and will hopefully have a large gain upon a liquidity event, but at least there will be liquidity for the taxes.

From the entrepreneur’s perspective, the favorability of the outright equity grant to the angel comes down to whether the entrepreneur’s share of the growth in the business’ value which will be achieved as the result of the loan from the angel, will be worth more than the value of the equity granted in the absence of the loan and the business’ growth which should result. If the entrepreneur is a good one, the answer should resoundingly be in the affirmative. A less positive way to put this is the adage, “100% of nothing is nothing.”

  • Also, the equity grant should be of shares or units which are in the same class as the entrepreneur’s (the painful discussion of preferred shares or units be gone!), and the shareholder or operating agreement should allow the entrepreneur to make the strategic decisions (A) whether the start-up will be acquired by another party (as long as the angel is treated equally with the entrepreneur on a pro rata basis, whether in the exchange ratio or cash distribution) and (B) whether to issue and sell new shares or units to a third party (again, as long as the angel is treated equally with the entrepreneur in terms of pro rata dilution and also the angel has a right to participate in buying new shares so there is no dilution if the angel steps up to the opportunity).

The net effect of the above structuring – “straight” debt at better than market for the start-up and a simultaneous outright equity grant to the angel – is a high degree of alignment between the entrepreneur and the angel. The angel, who in the first place is betting on the entrepreneur as an innovator and as a person, benefits in direct proportion to how well the entrepreneur does. When the entrepreneur does well, the lion’s or lioness’s share goes to him or her and some goes to the angel who helped make that possible. (Again the adage: “100% of nothing is nothing.”)

A high degree of alignment between the entrepreneur and the angel is a beautiful thing to see. Compliments to those who can achieve it – not only because of the mutual benefit to them of the business’ greater growth in value, but also because it does in fact water the tree of innovation.

What are your thoughts? Let's discuss: