You’re reading an excerpt of Angel Investing: Start to Finish, a book by Joe Wallin and Pete Baltaxe. It is the most comprehensive practical and legal guide available, written to help investors and entrepreneurs avoid making expensive mistakes. Purchase the book to support the authors and the ad-free Holloway reading experience. You get instant digital access, commentary and future updates, and a high-quality PDF download.
The rights in this section address how you can participate in or get impacted by future investment rounds. For example, if the company has to raise money in the future at a lower valuation, you do not want to get your ownership stake heavily diluted or “washed out.” If the company is doing well, you may want to ensure that you have the right to keep investing.
Investors may want the right to continue to invest and thereby minimize their dilution as much as possible as the company grows.
cautionSometimes investors ask to never be diluted below a certain percentage of a company. For example, an investor might offer to buy 5% of a company but want the company to obligate itself to never dilute the investor below 5% of the company. This is an unsophisticated and impractical request. There is no realistic, practical way to accomplish this in a company that expects to raise multiple rounds of funding. Remember, everyone gets diluted, including the founders.
To help you protect the value of your stock from dilution, you can negotiate for participation rights.
Participation rights (or preemptive rights) allow investors to invest in subsequent rounds to maintain their pro rata share. Super participation rights (or gobble up rights) allow you to buy more than your pro rata share, meaning the right to invest more if other investors do not exercise their participation rights in full.
Depending on how the provisions are drafted, you may not only have the right to buy your pro rata share but also shares covered by the pro rata rights of other stockholders who elect not to participate.
There are a few key components to a participation or preemptive rights provision:
The definition of pro rata.*
How much notice you are given.
If others don’t exercise, can you participate in their share as well?
What are the carve-outs?
There are a variety of typical carve-outs from participation rights, including:
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stock option grants;
issuances of equity to banks or commercial lenders;
issuances of equity to joint venture partners, or similar persons, the purpose of which is other than to raise capital.
Regardless of these carve-outs, if the provisions are correctly put together, on the next round you will be able to buy enough shares to restore your pro rata position. Realize though that in the future the valuation might get too high for you to continue to participate in any meaningful way.
Another option, if you are one of the very early investors, is to negotiate that your investment for X% of the company not be calculated until the company has raised at least some specified amount of money from third parties in a preferred stock financing. This is what accelerators and incubators frequently do in their contracts.
Right Of First Refusal
A right of first refusal gives the investors the right to buy the founder’s shares if a founder is going to sell them to a third party.
If you are very bullish on the company and want the opportunity to increase your investment, then this type of term can be useful. It is less common in angel deals than in venture deals, where founders may be looking to cash out some of their equity.
Sometimes, companies will want to impose a right of first refusal on investor shares. In such cases, you may want to ask for a right of first refusal and co-sale right on founder shares. Right of first refusal agreements often go together with co-sale rights, which give the investors the right to sell some of their stock if the founders are selling stock.
Control and Governance
Control and governance refers to how the company is controlled (hiring and firing officers, issuing equity, M&A transaction approval) and who controls it. The primary control mechanism is the board of directors and protective provisions. We covered a number of protective provisions within our discussion of preferred stock. Drag-along agreements are worth mentioning because they impact who is not in control of a transaction (potentially you).
If you are a significant investor, you may want to negotiate a board seat. We cover boards of directors and boards of advisors in detail in Boards and Advisory Roles.
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