Startup companies seeking to grow often look outside of the company to equity investment for the necessary funding to meet growth needs. The company exchanges an ownership interest (or right to purchase an ownership interest in the future) for investor capital. Normally, seeking outside funding happens in stages that have taken on a variety of names to characterize the nature of the funding. Notably, most companies start with personal contributions of company owners. This might include personal savings or borrowing. The next stage of investment is commonly referred to as “seed financing”. Seed financing is when the company seeks investment from outsiders that will allow the company to get to operational sustainability or to the stage of growth where professional investors, such as venture capitalists, will be interested in investing in the company. The seed investment stage is generally includes investment from friends and family investors or from angel investors. The investment activity is known a “round” of investment.
Characteristics of a Friends and Family Round
A friends and family round, as the name implies, is an investment round made up of either friends or family members. This is generally the first round of equity investment for a company. The company may not have fully developed operations, or even a dedicated revenue model, at this point. It generally takes place during the earliest stage of company growth. This can provide a major advantage to the early investors, as the company has a much lower valuation than if it were to seek investment at a later stage of growth. The investors are generally not sophisticated in equity investments. The investors will have diverse objectives, such as helping a friend or family member, earning interest on the money invested, earning a return when the company is later sold, or remaining an owner of the company forever.
The unique characteristic of a friends and family round is that it is generally far less complex than later rounds. At early stages of growth, a company may not have a developed ownership structure. For example, many early-stage companies may be organized as a limited liability company (LLC). In such scenario, the investors might receive a percentage interest or membership units of the LLC. If the company is organized as a corporation, the investors will generally receive shares of common stock. In both of these scenarios, the friend or family investor receives the same class of ownership as the entrepreneurs. It is rare that a company will offer or issue any form of preferred stock shares at this point. Preferred share authorization generally takes place at later stages of company growth and financing. Likewise, in limited cases, the company will use a convertible note instead of equity. The note is a debt instrument that will later convert into equity at a later date — usually during a future equity financing.
Characteristics of an Angel Round
Angel investors are wealthy individuals who use personal funds to invest individual or as a group in growth-based companies. Often angel investors are part of investment groups who pool resources to identify investment opportunities and consummate investment transactions. While not full-time investment professionals, Angel investors are far most sophisticated or knowledgeable in company financing than typical friends and family investors. Angels generally seek to invest in late, seed-stage companies in hopes of capitalizing when the company is later sold or undergoes a subsequent round of financing.
Angel investors generally invest through slightly more complicated transactions than friends and family investors. A typical angel or angel group will either invest through a convertible note, a Simple Agreement for Future Equity (SAFE), or require a form of preferred equity interest. As previously explained, a convertible note allows the investor to convert a debt instrument into an equity ownership interest at a later date. This allows the investor to avoid negotiating all of the terms of the equity financing at this early stage company growth. Instead, it defers these negotiations until a future round of equity investment. At that point, the investors can ping back on the type of equity purchased by the later investor. Later stage investors, generally large angel groups or venture capital firms, are more sophisticated investors and negotiate more thorough equity agreements. Similarly, a SAFE allows the investor the option to purchase equity at a future date. Both instruments generally put a cap on the company’s potential valuation in the future, and each may provide the investor a discount when converting the note or purchasing the future equity.
If the angel investor receives a form of preferred equity interest, the equity will generally provide a dividend preference, liquidation preference, and conversion rights. A dividend preference allows the investor to receive a dividend payment before all common shareholders. A liquidation preference allows the investor to receive a return of their money (or some multiple of their money) before other owners receive any funds from the sale of the company. Conversion rights allow the investor to convert their preferred shares into common share ownership if owning common shares is advantageous for any reason.
In summary, equity investments by angel investors are made in later-stage companies through far more complicated transactions.
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