Israel is brimming with high tech ideas and you want to be part of the action, one way to do so is by providing a start-up with early seed money.
But you need to protect your investment.
- The Target. Choose a start-up in a field that you understand, it will help you evaluate its chances of success. Remember founders can be picky too, they prefer angels who bring something to the table other than just money – contacts, distribution channels, expertise etc.
- Investment Deck. Ask for an investment deck and check it addresses the following questions to your satisfaction: What is the market need? How does the proposed product fill this need? What are competitors doing? How is the proposed product better? What is the proposed business model and budget?
- MOU. This should be a non-binding document that does not commit you to invest, but includes the material terms of the transaction. This is signed even before the material due diligence is conducted to ensure that everyone is on the same page and to avoid wasting valuable time and resources.
When drafting the MOU you should consider:
1. Lump sum v Installments. You do not need to part with your hard earned cash in one go. You can be more conservative and condition your investment on the company meeting certain milestones.
2. Equity v Convertible Loan. You do not need to commit now. You can invest by way of a convertible loan. This may be less risky as (i) you can ask for repayment if you are not happy with the company's performance, or (ii) you can convert into equity at the next investment round, on the same terms as the round and at a discount.
3. Company Valuation. At this stage the number will almost always be subjective. The founders will not want the valuation to be too low, because they do not want to give away too much of the pie. On the other hand you do not want it to be too high as: (i) you want a nice piece of the pie and (ii) you do not want a down round in the future (where the valuation drops), as this will dilute your holdings and may also deter future investors as it will reflect poorly on the company.
4. Anti-dilution. Whether full ratchet, broad based weighted average or narrow based weighted average, these anti-dilution protections will preserve your percentage holdings in a down round, or mitigate their dilution.
5. You want the target to have an employee share option pool and plan. You want the target to incentivize its employees and to attract the best talent. What you do not want is that the pool is created at your expense (i.e. by diluting your holdings). So ask that the company allocates a pool prior to your investment.
6. Do you want a seat on the board, to be an observer or would you be happy with information rights? Remember board members have duties as well as rights. If you are on the board, make sure the company agrees to indemnify you for your actions and purchases sufficient Director and Officers insurance.
7. General Terms. Most angels are minority shareholders, so make sure you include restrictive provisions preventing the company from taking certain actions without your consent – for example, changing the business of the company or selling the IP. You are taking a high risk at this stage so you want to guarantee a high reward, you could ask for dividend preference and liquidation preference. However, remember that your terms will set a precedent for the next investment round and the founders will be reluctant to give away too much.
8. Founders. Part of your decision to invest will inevitably be based on the identity of the founders, so make sure they will be around for the foreseeable future. Request a no sale undertaking, whereby they agree not to sell their holdings in the company for a certain period. Demand a co-sale right, so if the founders have a nice exit, you can benefit from it as well. Most importantly make sure the founders are dedicated, that they are engaged by the company on a full time basis and that this is not simply their hobby. You can also ask that if the founders cease working for the company within a certain period, the company will have the right to repurchase their shares.
9. No shop/Exclusivity. Despite the non binding nature of the rest of the MOU, the founders and company should undertake not to negotiate with other potential angels for a fixed period, buying you enough time to perform your due diligence and negotiate the definitive investment agreements without being undercut.
- Due Diligence. It might be that there is not much to review at this stage but performing due diligence (legal, financial and commercial) will put you in a much better position to gauge whether the start up will succeed. Is there a real market for the product? Does the company actually own the underlying intellectual property? What are the company's current debts?
Remember this is the start of a relationship, not an exit. No one likes to be bulldozed and the founders will be protective of their baby and may take flight if you are too demanding. Tread carefully but protect your money.
Originally published on April 10, 2016
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.