editione1.0.1Updated September 19, 2022
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 lead investor typically makes the decision on when to bring in legal counsel and who to hire to represent the investors. They will also lead the negotiation over who pays for legal fees to document the deal. The sections below are useful for the scenario in which you are responsible for, or have influence in, deciding when to bring in an attorney.
When you are first introduced to an angel investing opportunity via a pitch, you will likely get a very high-level summary of the proposed investing terms from the entrepreneur, such as:
“We’re raising $1M in a Series Seed on a pre-money valuation of $3M,” or
“We’re raising $400K in convertible notes with a 20% discount and $3M cap.”
Once you’ve read through Part III: Financings and Term Sheets, you will know what these terms mean and you can negotiate the pre-money valuation or the discount on a note without the help of a lawyer.
If instead you get a deal that does not look like one of the common forms that we describe in Part III, you might want to seek the advice of a lawyer to better understand what you are dealing with and determine whether it can be structured as something more familiar. As mentioned early on, you may save a lot of time and legal expense if you bring in a lawyer to help architect the deal.
Typically, if you (alone or as a group) and the entrepreneur agree on the top-level terms like the amount and the form of financing, the real action starts with the term sheet. Because angel groups often have forms for the most common term sheet types* and experienced lead investors within the group, it is common to get to a final term sheet without needing to engage counsel.
That said, it is often worth having the attorney who is going to be engaged in drafting the definitive documents review the term sheet, since they need to be comfortable expressing the agreed terms across a number of legal documents. Because term sheets are short and concise, it should not cost a lot to have a competent attorney review one (typically less than $1K). One of the benefits of working with an experienced attorney who specializes in early-stage investment transactions is that they can give you a sense of what terms are typical or unusual or highly favorable to one party. They can also help you craft rights that can mitigate legal and financial risks that you might be particularly concerned about for a specific investment. As you can imagine, legal time (and money) spent in the term sheet negotiation is usually much more efficient than trying to change terms once the definitive documents are being negotiated.
Whether you (as a group or individual) want to engage a lawyer for legal due diligence depends in large part on the history of the company you are considering investing in.
There are some scenarios in which you may not need to hire a lawyer for legal due diligence. If a company has just come out of an accelerator that takes an ownership stake as part of the program, or if the company has completed a prior financing round with competent investors who had skilled counsel, theoretically there is much less need to dig in deep on legal due diligence. Accelerators and incubators will typically clean up any pre-existing corporate legal issues as part of taking their own equity interest.
Similarly, if a company has worked with experienced legal counsel from the start, that should give you confidence that corporate matters are properly documented. In many cities there are law firms that will provide entrepreneurs with attractive packages of corporate formation documents, employee agreements, et cetera, and even act as secretary at board meetings. They provide this service at low cost as a loss leader, an investment in an ongoing relationship. They start to make their money when the entrepreneurs raise financing that has to be documented.
If neither of the above scenarios is true, remember that entrepreneurs are scrappy by nature, and legal counsel is typically expensive. So, if the startup has not worked with a competent law firm consistently, or if there are elements of a messy background you become aware of, you’ll want to have legal counsel review the company’s situation and standing.
exampleA company has been around for years and started out as an LLC, before becoming a Delaware C Corp. Some initial founders have left, and at some point the company sold off some intellectual property to raise money. They have raised some money in the past in the form of convertible notes from friends and family, and while the notes have expired, the investors are “patient.” They promised some equity to some former advisors and an early contract developer, but it was never properly papered because they were bootstrapping.
Any one of the details in this scenario is not as rare as you might think. Remember, good entrepreneurs are determined and will find a way to keep going despite obstacles. While it would be highly advisable to hire an attorney to review the company’s history in the above situation, you have a practical difficulty. If the company has not spent money on legal services along the way, playing catch up and cleaning things up that weren’t done right in the first place can be very time consuming and expensive. This is one reason to look for companies that have hired able and competent counsel and have taken the time to do things correctly.
Another potentially messy scenario, which is also not uncommon, is when a startup spins out of an existing business, having leveraged the earlier business’s employees and resources to develop the startup’s idea and assets. Pete has personal experience with this scenario, and raising the first institutional round for the spun-out startup required extensive legal documentation of the separation of the assets from the parent company and agreements with many of the employees of the earlier business to document their respective contributions, assignments, and ownership of the new business.
With the exception of perhaps a simple individual convertible note, as mentioned above, the lead investor will almost always have a lawyer representing the investors when the definitive documents are being negotiated and drafted. Often the lead investor will prefer to have their attorney draft the definitive documents. If you are investing alone, we recommend that you have a lawyer review the documents to insure that they accurately represent the terms negotiated in the term sheet.
Whether you should engage your own lawyer depends on a number of factors, including your level of experience, how much you are investing, and the context in which you are investing.
If you are investing as part of a group of experienced angel investors, and someone else in the group is the “lead” in performing due diligence and negotiating deal terms, then it is likely that you do not need your own lawyer. The group of angels with whom you are investing should have a lawyer representing their interests collectively, including yours. Angel groups often work with the same law firm for many deals, and so they usually have high confidence in that firm’s skills and experience.