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Updated August 29, 2023You’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.
In the sections so far covering the different investment vehicles, each section has included terms that are unique to or typically associated with that investment type. This section includes the general investment terms that could show up on any term sheet, regardless of the investment vehicle. We have touched on many of these terms already, but in this section we will go deeper.
We have grouped the terms into subsections, and you can use this chapter as a reference whenever you come across one of these concepts.
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:
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.
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 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.
If you do take a board seat, as part of the term sheet, you may want to insist that the company obtain directors and officers insurance to protect you in the event of a lawsuit. In addition, it is always a good idea to have a lawyer who is familiar with these insurance policies to work with company management and the company’s broker to make sure that you are getting a policy with the coverages you want and without exclusions that might leave you unprotected.
A drag-along agreement (or take-along agreement) requires those who sign it, ideally all of the company’s stockholders, to vote in favor of change of control transactions—to go along with the sale of the company or a sale of all of the interests in the company, including yours, even if you do not agree with the proposed sale and would otherwise refuse to go along or vote for it.
cautionLarger investors like drag-along agreements; as an angel investor, you would prefer not to be subject to a drag-along agreement. If you are presented with a drag-along agreement, make sure it has some checks and balances in it. You can see a drag-along provision with the appropriate investor protection in the Series Seed Stock Investment Agreement.
What if you made an investment in an early-stage company and never heard from them again; or only received documents to sign when they wanted to authorize more stock? Many investors like to know what is going on with their investments, and the rights described in this section make sure that you as an investor can get regular updates and access to management if you want that.
Information rights are the rights to receive certain information about the company at specified times—for example, the right to receive quarterly and annual financial statements, the right to receive an updated capitalization table from time to time, and the right to receive the company’s annual budget. Sometimes, information rights are only made available to investors who invest a certain amount in a financing (typically referred to in the investment documents as a “major investor”).
importantCompanies that go dark, or that do not communicate with their investors on a regular basis, can be a significant source of angst for investors. If an entrepreneur or lead investor (who might be a major investor while you are not) pushes back on inclusion of all investors in information rights, you can stress that there is no additional work required by the company. The documents are already being prepared, and they just need to add you to the electronic distribution list.
Inspection rights are the rights to visit the business premises, meet with management, and review the company’s books and records. Companies may have a legitimate reason to push back on giving all investors inspection rights, as it could be a significant drain on management’s time if they were obligated to meet with or entertain at their office a large number of individual investors.
You can find example inspection rights language in Section 3 of the NVCA example Investor Rights Agreement.
The reasons to push for these terms mirrors the reasons to push for information rights. However, because of the potential business disruption, inspection rights are usually reserved for major investors.
Observer rights are rights to attend a company’s board meetings as a guest, in a non-voting capacity. The ability to attend board meetings provides tremendous insight into what is happening at the company. However, often very sensitive information is discussed, and a company may be very reluctant to provide this right to anyone other than the lead investor for a particular round.
A company would typically prefer observer rights to include confidentiality language and the ability to exclude the observer to maintain attorney client privilege. An example of an observer agreement can be found in the appendix.
Terms in this section impact how and when you might get cash back out of the investment. We discuss liquidation preferences in the section covering preferred stock, since a liquidation preference is most typically a facet of a preferred stock financing.
Redemption rights (or put right) are the rights to have your shares redeemed or repurchased by the company at the original purchase price or some multiple, usually after a period of time has passed (perhaps five years). It is also possible to prepare these provisions to allow redemption in the event the company fails to reach a milestone, or breaches a covenant.
cautionBe aware, however, that even if you have redemption rights, if a company is insolvent it will not be able to legally satisfy a redemption demand. Under most states’ corporate laws, corporations are disallowed from redeeming shares when the corporation is insolvent either on a balance sheet or ability to pay its debts as they come due, and directors are personally liable if they authorize a redemption when the corporation is insolvent.
Redemption rights are not common in angel deals. However, they can be appropriate and a good mechanism to employ if a business has the danger of becoming a lifestyle business for the entrepreneur. If you want to put redemption rights in place in order to avoid a lifestyle business outcome, you will probably also want to put in place covenants, such as restrictions on founder salaries—perhaps subject those to the approval of a compensation committee composed entirely of independent directors—to ensure that the redemption rights will have value and are enforceable when they come due.
A registration rights agreement is an agreement of the company to register securities with the Securities and Exchange Commission so that the holder of the securities can sell them. When investors demand the company register the investors’ shares, it is so the investors can sell those shares on the public market and get liquidity—the liquidity goes to the investors, not the company.
Registration rights are not common in angel deals. However, it would be perfectly appropriate for an angel to ask to have the same registration rights granted to a future investor. The following language would suffice to achieve this:
⚖️legaleseThe company agrees that in the event that the company enters into a registration rights agreement with future investors in the company, the company shall include the Investors with the coverage thereof to the same extent and with the same rights as such future investors.
You can find an example of a registration rights agreement in the Investor Rights Agreement at NVCA.
The co-sale right (or tag-along right) is the right to participate alongside another stockholder, typically a founder, when that stockholder is selling their shares.
If the value of a company’s stock has gone up significantly, but it is still far from a liquidity event, and the founders are selling some of their shares to an outside investor, you may want to sell some of your stock and realize a gain. This right is useful if you are concerned that the founder might find a buyer for his or her shares and leave you behind.
In a world in which it can take ten years for a company to go public, it is reasonable that founders would want to sell some of their shares to take some money off the table and improve their lifestyle. As an early investor, you would like to do the same thing if they have found a buyer, which is why you want a co-sale right.
Representations (or reps) and warranties can cover a broad range of topics in a financing transaction and they typically get more thorough as the amount of money gets bigger. In general terms, a representation is an assertion that the information in question is true at the time of the financing, and the warranty is the promise of indemnity if the representation turns out to be false. For example, a company might rep that they have no unpaid salaries, or that they are not currently being sued. We address two more specific reps below.
If you want to get a taste of probably the most typical sort of representations and warranties companies give in private financings, you can review the representations and warranties in the Series Seed documents.
A capitalization rep or cap rep is a representation and warranty in a securities purchase agreement in which the company makes assurances to you about its ownership and capital structure. For example, the company may represent and warrant that it has authorized 10M shares of common stock and that it only has 2M shares outstanding. If they are wrong, the investor can sue for damages and remedies.
The cap rep is critical in a fixed-price financing. If the company does not give you a cap rep, how do you know much of the company you will own? This is true even in a convertible debt financing, although a cap rep is less common in those documents because the amount of the company you will own as a result of those transactions will be governed by a valuation to be determined later, or a valuation cap set forth in the convertible note.
Whenever you make an investment, you would prefer the company make a representation and warranty about the company’s financial statements. As an aside, you should take a look at those statements to see how much cash is left in the bank and what if any outstanding debts exist.
We’ve discussed some of the definitive documents specific to the different types of angel investment types above. Below are definitive document agreements that can be associated with a broad range of financings.
A Voting Agreement is an agreement between the voting stockholders of a company in which the parties agree to vote their shares in a particular fashion to ensure that certain persons or their designees are elected to the board of directors. The agreement must be signed by the stockholders, because under corporate law it is the shareholders who elect the directors of the company; if your agreement is just with the company your right will not be enforceable.
exampleA two-person company is owned 60% by one person and 40% by the other. The two parties could agree that they would each vote their shares to elect each other to the board of directors. This would ensure that the 60% owner cannot throw the 40% owner off the board.
exampleSuppose there is a company comprised of three equal owners. Absent a Voting Agreement, any two owners can throw the third owner off the board and out of the company. With a Voting Agreement, they can each agree to vote their shares to elect each other to the board. This wouldn’t prevent the board, by a two to one vote, from terminating the employment of one of the owners, but it would prevent the one terminated owner from being thrown off the board of directors.
cautionIf a company agrees to appoint you to its board of directors, that agreement is probably not enforceable, because only the stockholders of a company can agree to elect you to its board of directors, not the company.
exampleYou want to negotiate for a board seat of a company you are investing in. In the term sheet, the company agrees to enter into an agreement with you to appoint you to the board. Immediately after the closing, the existing board of directors passed a resolution increasing the size of the board by one person and appointing you to fill the vacancy. You got what you wanted; you are on the board. But at the next annual meeting of shareholders, a majority of the shareholders vote for an entirely different board, and you are thrown off. You go to your lawyer, and ask if he will start a lawsuit to enforce your right to a board seat. Your lawyer tells you: “Your agreement with the company is not enforceable. For it to be enforceable, you need that agreement to take the form of a Voting Agreement signed by a majority of the shareholders.”
An Investor Rights Agreement typically includes covenants or ongong promises on the part of the Company to provide the investors with certain rights. Those rights could include registration rights, participation rights, information rights, observer rights, inspections rights, protective provisions, and other covenants. The voting agreement may be part of the Investor Rights Agreement.
A good example of an Investor Rights Agreement can be found at NVCA.
The Investor Rights Agreement may contain protective provisions. Protective provisions are special voting agreement provisions which require a company, before it can take certain actions, to obtain the separate approval of a particular group of shareholders.
If you invest in Series Seed Preferred Stock, the typical protective provisions can be found in an example term sheet found at Series Seed.
Valuation is how much a company is worth; valuation and value may be used interchangeably, or valuation may refer to the process of determining a company’s value. A public company’s value is expressed by how much people are willing to pay for the shares on the stock market. For a private company, the company’s value is determined in negotiations between the founders raising money and the investors.
You may have heard of 409A valuations for startups.