

 What you should know about angel investors and convertible notes - wglb
http://dondodge.typepad.com/the_next_big_thing/2010/03/what-you-should-know-about-angel-investors-and-convertible-notes.html

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grellas
Nice write-up with a good explanation of the main features of convertible
notes.

With such notes, the startup and its investors essentially kick the valuation
question down the road. In an environment where subsequent fundings are highly
likely for quality companies, they can work fine; in today's dicier
environment, much less so.

One point about the author's cost/benefit comparison of legal fees for doing
notes as opposed to doing a straight Series A funding. If the angels are
friendly and do not push too hard to try to convert the Series A into a VC-
style round, the processing costs of doing the preferred-stock approach can be
as little as $5K. It is only the angel groups that function almost like VCs
that require the sort of complex transactional documents that will run costs
up to $25K+.

The potential for low-cost Series A docs, of course, is one more reason in
today's environment to go ahead and price the stock and do a Series A in lieu
of kicking the can down the road.

Of course, pricing has its own issues because this can take away flexibility
in how a board will price options as incentives for key people and will also
typically require the startup to do 409A compliance earlier in connection with
its options pricing (which in turn may add $5K to $10K to immediate costs).

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gruseom
Grellas, have you seen many deals involving convertible notes with fixed or
capped valuations? Care to comment on these? They don't, by definition, "kick
the valuation question down the road".

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grellas
Convertible notes are very company-friendly and institutional angels will use
valuation caps to balance the risk more in their favor. Since the caps are
really best guesses of what future valuation might be, they don't affect stock
pricing for the company going forward (a reasonable explanation of how they
work can be found here: <http://www.spartina.com/items/20685-convertible-note-
cap>) and so the valuation question actually does get deferred in a legal
sense.

In the deals we do, I tell founders to avoid using caps and they tend not to
be used since they create complications for the downstream funding by working
to give unduly steep discounts from actual Series A valuation in some cases.

Surprisingly, however, the issue usually doesn't even come up in most cases
because it is the institutional angels who will tend to insist on caps and my
clients normally avoid such angels, preferring instead to work with the
"successful entrepreneur" wealthy individual type of angel (who will either be
fine with using convertible notes without caps or, if he insists on putting a
value on the investment, will just push for a straight Series A investment -
again, if done on "friendly" terms, which these easily can be in such cases,
the cost associated with the investment might be $5K or so, thereby not
constituting any serious drain on, say, what is typically a $200K investment
or so).

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axiom
Stay the hell away from angel groups. Only deal with individual angels
investors.

Angel groups almost universally consist of large numbers small time
"investors" who don't really have the net worth to invest on their own. They
take months and months to make a decision, and will invest a smaller amount,
at a lower valuation than any individual angel.

I've yet to meet a single serious angel investor who's had anything positive
to say about angel groups.

~~~
pg
Yes; that stuck out for me too. In our experience, angel groups are a complete
waste of time.

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slvrspoon
Correct: angel groups and the author are a waste of precious time.

