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The Investment Process Flow
Below, we will walk through what an idealized process looks like when an angel group is investing in a preferred stock funding round. (We discuss the types of financings and the relevant terms in Part III, but you don’t need to know all those details now.)
A preferred stock round is usually closed in one or more coordinated “closings” when, after months of pitching, due diligence, and negotiation, the formal documents for all investors are signed and the funds delivered to the company at the same time. At that point the entrepreneur and team pop a bottle of champagne and collapse in exhaustion.
In contrast, convertible note rounds are often much simpler than priced rounds, and the process is typically much faster. The time between first meeting with an angel and the writing of the check can be as little as a couple of weeks (or even less). If the company is raising a large round through convertible notes, say $500K, and is pitching to angel groups, then the process will look much more like the process outlined here:
The pitch. A presentation by the CEO to an individual or group of angels using a slide deck to cover the key points of the business and often the top-level fundraising terms. The terms typically include the amount of money the company is hoping to raise and the pre-money valuation if it is a priced equity offering, or the valuation cap if it is a convertible note offering. In most settings, the pitch is followed by a question and answer session, where investors seek clarification on any aspects of the business or team. This whole process may take 20 minutes if there are multiple entrepreneurs pitching to a gathering of angels, or it could take an hour over coffee if you are meeting with an entrepreneur one-on-one.
The follow-up meeting. If there is investor interest from the pitch, the investor(s) will have a much longer meeting with the startup where the founder(s) provides more detail on many aspects of the business and perhaps demonstrates the product in detail. The investors have a chance to meet the other members of the team and ask detailed questions about the company’s technology, go-to-market strategy, customer traction, et cetera.
Selecting a lead. If after the follow-up meeting(s) there are interested investors, and they agree that the high-level deal terms offered by the company are acceptable (or likely to be negotiable), they will coordinate to select a lead investor among themselves and then start to plan the due diligence and more detailed negotiations of the term sheet. If the investors feel that the investment terms offered by the company are not acceptable, there is often an effort to negotiate the valuation and other key terms to an agreeable place before investors are willing to engage in time-consuming due diligence.
Commencing due diligence. The investors within the group will divide up the due diligence tasks. Typically over some number of weeks, the investors complete their diligence tasks and share their findings with the group.
Negotiation of the term sheet. If the early due diligence is looking favorable and enough investors signal their continued interest in investing, the lead investor will negotiate the primary terms of the investment. The terms of the deal depend on the type of financing, and are covered in Part III.
Agreement on the term sheet. If the investors and the entrepreneur cannot agree on the principal investment terms to be captured in the term sheet, the deal could fall through. The purpose of the term sheet is to ensure that all parties are in agreement on the principal terms before the costly work of preparing the definitive documents gets underway. A signed term sheet, usually contingent on a final round of due diligence, is a major milestone for all parties.
Final due diligence. A company may not want to let you talk to their big customers or take up a lot of their engineers’ time with a technical deep dive or review their employee contracts until they are pretty confident that a deal is going to get done on reasonable terms. That is why some diligence items may have to wait until after a term sheet is agreed upon to conduct an in-depth technical review, customer contract or customer number reviews, and review of some important legal items.
At any point in the due diligence process, red flags may emerge which cause some or all of the investors to drop out. More commonly, if investors discover issues that give them concern, they may try to negotiate for more favorable terms (such as a reduced pre-money valuation) that more accurately reflect the state of the company’s progress or its risk factors.
A B2B company may represent that it has six customers. Reviewing the contracts or talking to those customers may reveal that only two are paying, three are in free trials evaluating the product, and one is in negotiation but has not signed the purchase order. Investors may decide that the situation represents significantly less customer traction than they were led to believe and warrants a lower pre-money valuation.
In many cases, especially when a fund or other “institution” is among the investors, the lead investor will coordinate the results of the due diligence efforts into a final report summarizing the findings of the diligence team.
Investor commitments. Once due diligence is complete and the term sheet is negotiated, the lead investor will typically ask for firm commitments from the investors, including how much they will invest and contact details of the angel or the legal entity through which they are making the investment. This information will be included in the final documents along with the number of shares being issued and other key items.
Preparation and negotiation of draft definitive documents. The drafting of the definitive documents can start while due diligence is still ongoing. This is where the lawyers on both sides earn their money. The definitive documents for each deal type are covered in Part III.
Agreement on the definitive documents. If you have confidence in your lead investor and the law firm representing the investors, you may not need to invest the time in reading all of the definitive documents, though we recommend that you do, as it is often educational and generally prudent to understand the terms of your investment.
Closing. On the closing date, you should be prepared to sign and return documents (usually by email) and deliver checks or wire funds to the bank account specified by the company. You will typically know the closing date a few days in advance, though sometimes it can be a moving target as issues come up during the final document negotiation and preparation.
When Are You Committed?
Legally you are not committed to the investment until you sign the definitive documents and send in your check. Typically both the entrepreneur and the lead investor will be checking with investors throughout the diligence and negotiation process to gauge the level of interest and commitment of each investor. An entrepreneur will want to know whether he or she is negotiating over $100K or $500K of collective angel investment, so they will likely also be checking with investors. It is normal for investors who expressed initial interest to drop out because they discovered issues in due diligence that make them less enthusiastic, or because they do not like where the terms negotiation ended up, or because of other time or financial commitments that arise for them during the weeks or months that the process takes.
Angels are free to increase or decrease their intended level of investment as they go through the diligence process and term sheet negotiation.
important No one should complain if you decide anywhere in the process that you will not invest or will invest less than you had initially indicated, until you are asked for your firm commitment from either the entrepreneur or the lead investor. Firm commitments are used to generate the definitive documents, so pulling out after those are generated likely requires more work and legal costs for the parties involved and would be viewed as very bad form. If you are making a verbal commitment or “handshake deal,” we suggest following Y Combinator’s handshake deal protocol.