Let’s assume that this an angel writing you a check for a convertible note.
To take one step back, an angel investor is a high net worth individual who provides a company with a loan with the expectation that their loan will convert to equity ownership (shares) at a later date (e.g., 1-2 years) when a company’s valuation can be determined.
In other words, company founders get fairly quick, low to no interest cash, which they repay with ownership equity at maturity.
Now to your question – the “legal” factors is broad, but I’ll talk about a growing trend I see for angel investors.
Up until several years ago, pro-rata rights were given to larger investors in later rounds, and less so to angel investors. However, it is now becoming increasingly common to find angel investors demanding pro-rata participation. The reason is a purely economic one: there’s simply a whole lot more angel investors with a whole lot more cash. The result is that tech startups have access to far more capital than ever before. What you’re seeing now is the mushrooming of larger tech startups with pretty beefy capitalization. Combine that with unprecedented speed in their growth and that means more companies that are giants by the time of an IPO.
I always find an example is helpful in demonstrating a concept. Let’s say Angel puts $500k into your company for a 10 percent ownership interest. If the company raises $20 million on the next round, Angel might not be able to inject the $2 million that would be required to preserve their 10 percent ownership stake. As you can see, even if this angel were given pro-rata rights, it doesn’t mean they would be able to execute them, since in this example we’re assuming that the investor doesn’t have the cash to keep their 10% stake. You can see how easy it is for an angel to feel like they’re being pushed out by the more weighty investors in the room.
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