Happy New Year, everybody! Having placed three angel investments during a single year, 2017 was a big year for this investor. While I primarily invest for dividends and cash flow (via dividend-paying stocks and real estate), I now allocate around (but no more than) 10% of my portfolio to higher risk angel investments. While these investments can carry higher risk, they can also provide a massive source of capital that can later be re-deployed in more traditional cash-flow investments. It’s a way of investing in people I know and support, while supercharging my returns. And, I’m at the stage where this strategy (and exposure to risk) makes sense.
As a side note, I recently wrote a blog post on My Angel Investing Strategy. If you have not read it yet, that post provides some great background on my overall angel investing strategy.
During 2017, two of my angel investments were very early stage ones. Meaning: I invested before an official valuation had even been placed on the company. (Typically, valuations for private companies are assigned during the first big institutional investment of around $6,000,000 or more.) Pre-institutional funding, many startups are choosing to go the SAFE Agreement or Convertible Note route. And, it makes sense because pegging a valuation and partaking in a traditional funding round can be very expensive for the company at such an early stage.
While I’m not an expert by any means, today’s blog post highlights my experience with these types of investments. I want to discuss what they are, how they work, and the pros/cons of investing in these types of early stage investments.
My Angel Investing Video
Before we even start with today’s post, I want to share a recent YouTube video that highlights many of the concepts discussed today. If you prefer video instead of reading, this video will definitely be for you. If you really want to learn these concepts, you may consider watching the video and reading the post!
What Are SAFE Agreements?
SAFE stands for Simple Agreement for Future Equity. Basically, when one invests in a SAFE Agreement, they do not own any equity in the company, yet. However, at some point in the future, the SAFE Agreement will convert into equity.
What Are Convertible Notes?
Convertible Notes are quite similar. A note is a debt instrument. Basically, the investor is lending the company money. Typically, interest rates are very low (the minimum required by law). At some point in the future, the expectation is that the note will be converted into equity. Convertible notes can operate in a very similar manner to SAFE Agreements.
Key Point 1: Get A Sense of Timing
When investing in SAFE Agreements and/or Convertible Notes, it’s critically important to understand timing of the equity conversion event. The whole goal of these investments is the conversion event into equity.
Typically, such instruments will convert into equity at the time of the first big institutional funding event (typically around $6,000,000 or more). As an angel investor, I exclusively invest in people that I know (very well). I get to know the operations of the company, and often become a partner of the company. The closer we are to the perceived equity conversion event, the better. In my modeling, I always add a buffer since conversion typically takes longer than anticipated. As a general rule of thumb, I like SAFE Agreements and Convertible Notes that have a perceived conversion event within the next year.
Worth noting, institutional equity financing sometimes takes longer than expected. I really like instruments that offer a failsafe. Some agreements will have a valuation cap that is used as the equity valuation should there be no equity financing within a specified amount of time. For example: If there’s no equity financing within x number of years, there may be a clause that just converts your SAFE or Convertible Note into equity stock pegged at y valuation. (Side note: Just make sure the valuation seems reasonable, based on all present data available.)
Key Point 2: Understand The Discount
With these types of angel investments, your money is not going to really grow until after the equity conversion event. Once the equity conversion event happens, my expectation is that I will earn several hundred percent (or more) return on investment. Until then, however, my money is essentially tied up.
Being tied up, I always want to get some type of reward. In my experience, this reward comes via the discount factor. Meaning: There will typically be a discount given to early investors at time of the institutional financing event. Let’s say a company raises x million at y per share valuation. If one’s SAFE or Convertible Note has a discount provision, the early investor will receive their equity stake at y per share minus the discount!
This is the reward for investing early, and allows one’s total dollar investment to generate more shares (than if one had waited and invested along side the institutional investor). As a rule of thumb, I expect discount factors to be in the 10% to 25% range, depending on level for risk and anticipated timing of the conversion event. In my experience, this is a reasonable level of return for one year’s time, in a higher risk angel investment.
Key Point 3: Understand The Valuation Cap
Valuation cap sometimes differs based on agreement. I want to offer two scenarios where valuation cap may enter one’s angel investing agreement.
Scenario 1: Runaway Valuation Insurance
Let’s say the perceived valuation of a company right now is quite low. Let’s say you’re getting in very early and it’s only worth a few million dollars or less. However, let’s say that the company grows quickly. By the time the instrument converts over to equity, let’s say hypothetical valuation is $100 million or more. If one’s discount factor is just 10%, one’s instrument will convert over at a $90 million valuation, hardly a good deal for the risk being undertaken! (And, hardly the upside that the investor should experience being an early supporter and advocate.)
Sometimes, valuation caps are used to protect investors in this very scenario. Let’s say there’s a hypothetical $10 million valuation cap. At time of the institutional funding, some agreements read that the conversion valuation is the lesser of (1) the valuation at time of funding minus the discount factor or (2) the valuation cap.
Scenario 2: No Institutional Financing Event
Let’s say several years have passed by without an institutional financing event. Meaning: No company valuation has been pegged. Some agreements read that, at a specified date, the SAFE or Convertible Note will convert into equity at the valuation cap. For this reason, it’s very key that one is comfortable investing at the valuation cap level, based on all information available and all due diligence performed.
Key Point 4: Avoid Buy Out Clauses
Investing in SAFE Agreements and Convertible Notes is risky business. It’s also an incredible amount of work. The goal of the work is getting in early and eventually owning equity for one’s hard work. (Of course, it’s also rewarding investing in those your truly care about.) As such, it’s critical to search such agreements for any potential buy out clause. Meaning: I typically won’t sign anything if the company has the right to simply buy out my agreement for the same amount I invested (plus a nominal interest rate). It’s just not worth my time and risk to invest in such instruments unless I have a very high level of confidence that the equity conversion event will happen.
Key Point 5: Be Prepared For Tied Up Money
Once someone invests in an angel investment, the money is tied up for a very long time. In fact, when I make such investments I assume I will never see the money again. If one is not willing to lose it all, such investments many not be the right fit.
In reality, I have never lost money on an angel investment, and my track record is impeccable. After all, I only invest in people and companies that I know personally. I’m quite picky. That said, I approach each deal with the same philosophy that I will not see my money for a long, long time, if at all. Of course, I never invest money in such instruments that I would need anytime soon (if ever). Building a business is hard work. It takes a long time. It takes even longer for investors to be rewarded.
Key Point 6: Make Sure You Are An Accredited Investor
When it comes to angel investments, there are two general types of offerings. The first class of offerings are under Rule 506(b), meaning the company raising funds is not actually advertising the investment opportunity. These are the types of opportunities that investors, like myself, literally find by reaching out and asking, "Hey, can I invest in your company." The second class of offerings are under Rule 506(c), meaning the company raising funds is able to actively market the investment opportunity. The company can actually reach out (via social media and other means) and advertise the investment opportunity.
Both 506(b) and 506(c) offerings require the investor to be accredited. However, 506(c) offerings require official verification of one’s accredited status (often by a third party service that specializes in such accreditation).
The key point here is to make sure that one is an accredited investor. If one is not, then angel investing is not going to be an option. However, there are a few hacks: (1) Become an "angel investor" by working at a company and earning employee stock options (this has been a hugely valuable strategy in my own career) or (2) start your own company. While it may seem like a bummer, these rules actually help safeguard investors from risk.
Key Point 7: Don’t Forget To Give Back
What’s the point of all this investing and money? At the end of the day, it offers financial freedom and opportunity. It offers the opportunity to pursue one’s dreams! Also, it offers the ability to give back and help others. I love giving back, and even created a website called Lopuch.org to journal our charitable contributions. The more one earns, the greater their responsibility to give back and help others. And, I think you will find that the act of giving back is actually more rewarding than even making the money!
Thanks for reading, and I wish you all the success in the world in your investing and beyond!
Disclaimer: I am not a licensed investment advisor and today’s post is not investment advice. This post is just for fun and entertainment. If you are going to invest in angel investments (or anything else), please consult a licensed financial advisor first.