angel investing

Angel Investing: My Experience With SAFE Agreements

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.

Angel Investing: My Approach

By PPC Ian Leave a Comment May 3 1

Recently, I made two angel investments in startup technology companies, signifying my first angel investments in five years. As someone who is a true dividend growth investor, I tend to be incredibly picky when it comes to early stage opportunities. Typically, I stick to big name blue chip companies that have:

Dock and Water

Long track records of raising dividends year-after-year
Huge cash on hand, huge cash flow, and very little (or no) debt
Competitive moats (barriers to entry) that are almost impossible to overcome
Compelling prospects for many decades into the future (my horizon is: never sell)

That being said, I am a Silicon Valley business executive who truly gets excited about early stage companies, especially in the high tech arena. From time-to-time, I’m able to find a great pre-IPO angel opportunity and I’ll go for it. Today, I want to share my personal philosophy on how I approach these types of investments.

Invest In People

At the end of the day, I will only invest in angel companies where I personally know the founder. Small companies can be risky. Small companies oftentimes have to pivot their business strategy. My last angel investment from about 5 years ago is a perfect example of this. I invested in a business that has completely transformed over the years. While the original model had to evolve, the team pulled through and built an incredible, thriving business. In fact, what they have built now is even more exciting than what I ever imagined in the beginning.

With small companies, you are investing in people. It is impossible to invest in a person unless you have a friendship with them. While this can greatly limit your opportunities, it can help you make accurate decisions based on character, intelligence, leadership skills, and sweat equity.

I’m able to quickly filter towards people who are "going places". These are the people I invest in, when the opportunity arises. Build your ability to read people and surround yourself with people that are going places.

Be Patient

It’s a pet peeve of mine that people these days list all of their angel investments on their LinkedIn profiles. I understand if you are a venture capitalist or full time angel investor that this may be important because of your profession. In that case, it makes logical sense to me. However, if your career is somewhere other than venture capital or angel investing, I personally suggest keeping things more confidential. Sure, you may want to list one or two investments, especially if you have taken a large-commitment advisory role or board of directors role.

However, I feel sometimes like people are just investing in a lot of companies to make themselves look more "legit" on LinkedIn. I feel like some of these people are rushing into a lot of investments without exercising patience. Also, they may even be spreading their capital (and time) too thin, without really going big on the investments that matter. This isn’t a popularity contest, this is investing capital for your and your family’s future. The greatest investor around, Warren Buffet, has described his investment strategy as lethargic. He has no problem waiting around for years (or even a decade if he has to) for the right opportunity.

I’m really trying to encourage patience here. There is no rush. There is no need to impress anyone online with your investments. Wait for the right pitch, even if it takes five years (as in my case).

Cultivate Relationships

The best angel investment opportunities are not open to just anyone. Those that have a good thing going don’t need just anyone’s money. They can be picky. They can choose investors who can add value to the company (and they absolutely should). If you have a friend who is building a unique business, understand how you may be able to add value. Can you do some part time consulting to help them out? Can you offer some advice? Are you willing to be on their board of advisors? Are you willing to be patient, until they are ready for your investment? The best investments take time to cultivate. Don’t be in a hurry. Keep your eye on the long-term. More than anything, be a friend and do the right thing for your friendship.

Focus on Financial Performance

I only invest in angel opportunities that exhibit the following combination of qualities:

Strong top-line revenue growth (I will not invest in companies pre-revenue).
Reasonably strong earnings (It’s ok for an early stage company to break even or even slightly lose in an effort to reinvest in the business, but it’s not ok to lose a ton of money).
Strong assets (Whether the assets be intellectual property, an amazing platform, or even world-class domain names, I like to invest in companies that have tangible value).
Willing and able to share financial statements: balance sheet, income statement, cash flows, and other financial documents upon request. (Invest in those teams that are willing to offer transparency.)

Be a Lawyer

I’m proud that my roots are in digital marketing because that profession taught me many skills across disciplines. One area where I feel I am quite strong is the review of legal documents and contracts. When investing in early stage companies, make sure to review all of the documents thoroughly. If something does not look right to you, offer to redline the document yourself (or with the help of your counsel, if you prefer). When it comes to these types of investments, it’s often good to have another pair of eyes as well to make sure all the documents look perfect.

And, don’t feel bad if you missed something. In one investment I just entered, we later found a minor typo. I drafted an amendment and we immediately executed the amendment. (Another reason to invest in people you trust and know.)

Know Where You Stand

As companies raise money, it’s important to understand where you stand. Get your hands on the cap table. The cap table, typically an Excel document, will feature the various rounds of funding, who invested, how many shares each person owns, the valuation at each round of funding, and so much more. This is a living document that you should use for your personal records as well. Angel investments can be illiquid. When the liquidity event comes ten or fifteen years from now, it’s always helpful to have the original cap table so you know your exact level of ownership.

Have A Long-Term Approach

Publicly-traded stocks are liquid. You can buy and sell whenever the market is open. Angel investments are not. Your money could be tied up for an incredibly long time. I approach angel investments with no expectation of getting my money back. I’m not saying this in a negative way. I only invest in companies I truly believe will thrive and flourish. Rather, I’m saying this in the most positive way that I’m a long-term partner. I want to leave my money in the investment as long as possible, so it can keep growing. And, that’s what often happens with illiquid investments anyways.

Get Creative

While I’ve successfully completed a handful of angel investments outside of work, most of my private company investments have come via work. In my earlier career, I made a habit of working for pre-IPO companies on the ascendency. Via my hard work and sweat equity, I was rewarded stock options. These stock options allowed me to eventually own shares in three successful early stage companies (one bought out by private equity for $1.2 bln, one went public, and one had a division acquired for $100 mln with shareholders retaining equity in the rest of the business). These days, I’m a Partner at a commercial real estate firm and plan on building up a real estate portfolio, over time, through hard work and sweat equity. If you don’t have a lot of money to be an angel investor and want to be one, go the employment route. Choose your employers wisely.

That being said, don’t rule out publicly-traded companies. Stock options are still valuable at publicly-traded companies as well, and I lived that scenario first hand as well.

Diversify

On a closing note, I want to reiterate that angel investing is very attractive because it’s the "cool thing". I worry that the allure of it draws people in for the wrong reasons and also convinces them to take undue risk (too much money invested in companies that have not been fully researched and proven). I personally like to diversify and keep these types of investments as a smaller part of my portfolio. Even if one of my investments fails, I can sleep at night knowing that I have diversified wisely.

All this being said, I do want to say that there is something special about investing in people, which brings me back to my first point. Angel investing is unique in that you are really helping make dreams come true for people that are important to you. That is amazing and should be celebrated.

Disclaimer: This blog post is for entertainment purposes only. I am not a licensed investment advisor and this is not investment advice. Please consult your licensed investment advisor before making any investment decisions (including angel investments).