The Angel Capital Association 2021 Summit—is there any hope?

The Angel Capital Association 2021 Summit—is there any hope?

 

Have you ever attended a conference and felt so at home—like the attendees are really your people?  When I go to the Angel Capital Association conference, I feel exactly the opposite!  Most of the people I meet there don’t understand why anyone would be concerned about the impact of their investments beyond the impact of making the angel investors rich.  Most of the talk is bragging about that 47x exit that they got (i.e. they got a return of 47 times their original investment).  

I went ahead and applied to speak at the conference about “alternative” investment models because it is my mission to spread the word about non-extractive, sustainable ways to invest.  I was shocked when my proposal was accepted!  I decided not only to attend the panel I was on, but to attend the whole conference and try to keep an open mind.  Maybe the world of angel investing was starting to evolve?

When I looked at the agenda, I noticed that almost 20% of the sessions had the word “exit” in the title.  This, and the content of most of the sessions, confirmed that most active angel investors continue to rely on “exits” (via acquisition or IPO) to get paid.

The session I was invited to speak at was called “The Art of the Deal: Alternative Deal Structures.”  I decided to be honest about my opinion of the sacred cows of angel investing.  Luckily, another member of the panel, Drew Tulchin of New Mexico Angels (a member of Social Venture Circle and formerly of Meow Wolf) was equally willing to share his critique.

Here are some excerpts of what I said:

“When we talk to angel investors about ‘alternative structures,’ there is an assumption that alternative structures are debt and that equity has to be structured using the typical angel/VC style term sheet. . .There are many ways to structure equity.”

“I wonder about the wisdom of relying on a big exit as the only way to get paid.”

“The model where you push for an exit is not appropriate for 99.9% of businesses in our country.  And that doesn’t mean those businesses are “lifestyle businesses” or not investable.  They could go huge.  Only 6% of fortune 500 are venture backed.”

“Women are less likely to found companies that are on the high growth path.  If you want to diversify your portfolio, focusing on that one structure may not be consistent with that.”

 

Drew said,

“We have lawyers with a narrow experience set so they will only offer a couple products off the shelf.  If I have a good lawyer, that person should be able to take the vision and turn that into a thing that reflects our interests.  And if your lawyer or CPA or whomever can’t do that, you should encourage them to go educate themselves and not be so lazy.”

“I think the 10x language is a lot of bluster.  I would much rather see five to six companies get doubles out of a portfolio of ten than get one or two that go to the moon and everyone else goes to zero.”

 

As you can imagine, our comments did not go over well.  Here is what some of the attendees said:  

“We need to keep deal structures pretty standard, especially if future institutional funding is expected.  Using the standard terms on the National Venture Capital Association’s website has been very helpful.”

“I believe the great majority of angel investors want to help grow companies to a successful exit.”

“Most angel investors want to invest in companies that will have an exit.”

“In MOST cases exit is the right path.”

“A lot of complex “creative” deal structures don’t really help . . . the reason the VC route happens over and over is because so many lawyers have a basic understanding.”

“I would argue that if the entrepreneur doesn’t want to drive to an exit, we shouldn’t have invested in the business in the first place.”

 

We did get a few supportive comments acknowledging that there is, in fact, a category of business that can be successful and grow big without having an exit.  Unfortunately, this seemed to be very much a minority view among the attendees of the conference.  My hope is that Drew and I might have planted some seeds that will bear fruit some day as more investors become increasingly open minded about investment structures that support a livable, prosperous, and sustainable world for all.

You don’t have to sell your company for your investors to exit!

You don’t have to sell your company for your investors to exit!

When you raise money from investors, many of them will want to know how they may someday get their money back out of your company.

When people invest in public companies, it is very easy to exit from one investment to another—they just tell their online broker to sell Apple and buy Google.  

But with investments in private companies, the exit may not be so easy.  If you offer debt to investors, the way they will exit someday is spelled out in your promissory note.  At some point, you will pay your investors back their initial investment (principal) plus interest.

What if you offer an equity investment, however?  In the venture capital model, used for high growth tech startups, the exit from an equity investment usually happens when the company is acquired by another larger company.  But what if you don’t want to focus all your energy on that kind of exit?  When you know your investors are expecting you to sell your company to the highest bidder as quickly as possible, you may be forced to do things that are not in alignment with your goals, values, and how you want to live your life.

What if your investors could exit without you having to sell your company?  Well, they can!  There are a few ways this can happen, but in this article, I will focus on redemptions.  A redemption is when you buy equity back from your investors.  You can build this into your investment terms right from the start so that both you and your investors are clear on how they may someday exit.

Your investor’s ability to redeem his or her stock will depend on the exact language you put in your legal documents.  Our clients usually offer the ability for their investors to request a redemption at a certain predetermined price.  If your company is unable to honor the request due to insufficient cash for operations and reserves, you can delay or refuse the redemption or can pay the redemption in the form of a promissory note.  You can also offer a “mandatory redemption right” that requires the company to redeem the equity whenever the investor wants (this right often doesn’t kick in for several years after the initial investment).  Keep in mind though that there is really no such thing as a truly mandatory redemption right.  If your company does not have enough cash to meet its obligations to its creditors, it cannot legally redeem investor equity.

To learn more about all the ways that your investors can exit without you having to sell your company, consider joining our Capital on Your Terms Community—this is a great way to get literate about fundraising and make sure you know all your options for raising money on terms that will be sustainable for you and your business.

Should you provide anti-dilution protection for your equity investors?

Should you provide anti-dilution protection for your equity investors?

Anti-dilution protection is a set of provisions that you can include in your governing document (articles or certificate of incorporation) that are designed to protect equity investors in the case of a reduction in the price of your stock.

Before we talk about anti-dilution protection, we first need to talk about conversion rights.  Conversion rights are the right of your preferred investors to convert their preferred stock to common stock.  Why would they want to do this?  When the company is sold, the buyer generally will want to buy common stock, so at that time, preferred shareholders would convert to common in order to receive their share of the proceeds of the sale of the company.

When you offer preferred stock to investors, they often come with the right to convert the preferred stock to common stock on a 1:1 basis.  So, if an investor has 100,000 shares of preferred stock, they can convert those shares to 100,000 shares of common stock.

Anti-dilution protection is a mechanism that changes that ratio in the case of a decrease in the value of the preferred stock.

There are different formulas that can be used to adjust the ratio.  A very commonly used formula is called the Weighted Average method.  The following formula is used to provide an adjusted number of shares that one share of preferred stock converts into, with the idea that one share of preferred stock will convert into more than one share of common stock as a way to protect the early investors from losing all of the value of their initial investment:

CP2 = CP1 x (A+B) / (A+C)

Where:

CP2    =     Conversion price immediately after new issue

CP1    =     Conversion price immediately before new issue

A        =     Number of shares of common stock outstanding immediately before new issue

B        =     Total consideration received by company with respect to new issue divided by CP1

C        =     Number of new shares of stock issued

Here is an example to illustrate how this works:

When you first start your company, you issue 2 million common shares to the founders.  Then, let’s say you raise $500,000 from investors by offering preferred stock at $1 per share.  One year later, you raise $1,000,000 at $0.80 per share (meaning you sell 1,250,000 shares).

CP1 = $1

A = 2,000,000

B = $1,000,000/$1 = $1,000,000

C = 1,250,000

So, the new conversion price =

1 x (2,000,000 + 1,000,000)/(2,000,000 + 1,250,000) =

1 x (3,000,000/3,250,000) = $0.92

This means that the first preferred stock investors now convert into 1.09 shares of common stock ($1.0 /$0.92 = 1.09).

So, if the company is sold and those investors convert into common, they will get a larger share of the total proceeds from the sale than they would have if there were no anti-dilution protections.

Should you offer this protection to your preferred equity investors?

If you think it is likely that you may sell your company someday and the proceeds from the sale will be an important component of how your investors will be compensated, anti-dilution protection is a nice way to provide some protection to your early investors.  More sophisticated investors might insist on it.

On the other hand, these provisions can be rather complicated and require you to keep track of conversion ratios that might change if you raise more than one round of equity funding.  If you don’t foresee a sale of your company, it could make more sense to leave out provisions related to conversion of preferred stock to common altogether.

If you would like to become an expert on investment terms and other topics related to fundraising for your business, join our Capital on Your Terms Community!  For details, click here: https://www.jennykassan.com/capital-on-your-terms-community/

New rules—New possibilities!

New rules—New possibilities!

The Securities and Exchange Commission has made some changes to the rules governing private offerings of securities.  These are some of the biggest changes we’ve seen in a while and many of them will make fundraising much easier! The new rules are expected to go into effect by February 2021. Note that none of these rules pre-empt state law, so it is always necessary to determine whether applicable state laws may limit the usefulness of these new rules.

Integration

The integration doctrine seeks to prevent an issuer from improperly avoiding registration by artificially dividing a single offering into multiple offerings, such that Securities Act exemptions would apply to the multiple offerings that would not be available for the combined offering.  In practice, the integration doctrine often results in us telling our clients that they must have a six-month quiet period between two types of offerings. The SEC has done away with all of the old integration rules and created a new rule that will make things a bit easier for anyone doing a series of offerings under different rules. The new rule creates some “safe harbors,” which, if you comply with any of them, you don’t have to worry about your offerings being integrated.  Below are two of the more important safe harbors:

  1. If two offerings are separated by 30 days they won’t be integrated, provided that for an exempt offering for which general solicitation is not permitted, the safe harbor would require either: (i) that the purchasers were not solicited through the use of general solicitation, or (ii) that the issuer established a substantive relationship with the purchasers prior to the commencement of the offering.  Where an issuer conducts more than one offering under Rule 506(b), the number of non-accredited investors purchasing in all such offerings within 90 calendar days of each other would be limited to 35.
  2. An offering made in reliance on an exemption for which general solicitation is permitted will not be integrated with a previous terminated or completed offering. 

If none of the safe harbors apply to your situation, there is a general principle that you may be able to use.  The general principle under the new rule is that offers and sales will not be integrated if, based on the particular facts and circumstances, the issuer can establish that each offering complies with an exemption from registration. However, there is a caveat related to whether one of the offerings involves public solicitation.  For example, let’s say you start with a Rule 506(c) offering (which permits public solicitation) and then you stop that offering and switch to an offering under Rule 504 (which does not permit public solicitation).  In that case, you can only avoid integration of the two offerings if you have a reasonable belief, based on the facts and circumstances, that none of the purchasers in the Rule 504 offering were solicited through public solicitation or that you have a substantive relationship with each purchaser that was established before you started the Rule 504 offering.

General Solicitation

Exemption from General Solicitation for “Demo Days” and Similar Events  The new rules provide that certain “demo day” communications will not be deemed general solicitation.  This means that if you are conducting an offering under Rule 506(b) (which prohibits general solicitation) for example, you can go to a demo day that meets the requirements of the new rule and tell the people in attendance that you are raising money without worrying about whether you are violating the rules against general solicitation. The event sponsor must be a college, university, or other institution of higher education; state or local government; a nonprofit organization; or an angel investor group, incubator, or accelerator.  The event sponsor is not permitted to: 

  • Make investment recommendations or provide investment advice to attendees of the event
  • Engage in any investment negotiations between the issuer and investors attending the event
  • Charge attendees of the event any fees, other than reasonable administrative fees
  • Receive any compensation for making introductions between event attendees and issuers, or for investment negotiations between the parties
  • Receive any compensation with respect to the event that would require it to register as a broker or dealer under the Exchange Act, or as an investment adviser under the Advisers Act

Advertising for the event may not reference any specific offering of securities by the issuer, and the information conveyed at the event regarding the offering of securities by or on behalf of the issuer is limited to: 

  • Notification that the issuer is in the process of offering or planning to offer securities 
  • The type and amount of securities being offered
  • The intended use of the proceeds of the offering 
  • The unsubscribed amount in an offering

Online participation in the event is limited to: (a) individuals who are members of, or otherwise associated with the sponsor organization (for example, members of an angel investor group or students, faculty, or alumni of a college or university); (b) individuals that the sponsor reasonably believes are accredited investors; or (c) individuals who have been invited to the event by the sponsor based on industry or investment-related experience reasonably selected by the sponsor in good faith and disclosed in the public communications about the event. 

Testing the Waters:  The new rules create some ways that a business can “test the waters” with potential investors before doing any legal filings.  This means that you can talk to potential investors about your offering and gauge interest and solicit feedback before doing the legal work required to formally launch your offering.  There are two new rules for testing the waters—one applies to the situation where you still don’t know what exemption you plan to use for your offering, and the other one applies when you plan to use Regulation Crowdfunding.

Generic Testing the Waters Exemption—before you know what exemption you want to use

This new rule allows you to tell potential investors that you plan to raise money and ask for their feedback.  You must provide the following disclosures to anyone you talk to: (1) You are considering an offering of securities exempt from registration under the Act, but have not determined a specific exemption from registration you intend to rely on for the subsequent offer and sale of the securities.  (2) No money or other consideration is being solicited, and if sent in response, will not be accepted. (3) No offer to buy the securities can be accepted and no part of the purchase price can be received until it is determined which exemption will be used and, where applicable, the filing, disclosure, or qualification requirements of such exemption are met.  (4) A person’s indication of interest involves no obligation or commitment of any kind.  Under the new integration rules, you will not be able to follow a generic solicitation of interest that constituted a general solicitation with an offering pursuant to an exemption that does not permit general solicitation, unless you have a reasonable belief that the purchasers were not solicited via general solicitation or you have established a substantive relationship with them.

Regulation Crowdfunding Testing the Waters Exemption

Under the current rules, you are not allowed to tell anyone that you are raising money under Regulation Crowdfunding until you have filed your Form C.  Under this new rule, you can talk to potential investors to gauge their interest as soon as you decide that you want to do a Regulation Crowdfunding campaign. You need to provide everyone you talk to with the following disclosures:

  • No money or other consideration is being solicited, and if sent, will not be accepted. 
  • No sales will be made or commitments to purchase accepted until the Form C offering statement is filed with the Commission and only through an intermediary’s platform. 
  • Prospective purchaser’s indications of interest are non-binding.

Regulation Crowdfunding Offering Communications 

The new rules slightly expand what you are allowed to say during your Regulation Crowdfunding campaign.  The rules now explicitly permit oral communications with potential investors and expand the information you can provide outside of the platform to include:

  • A brief description of the planned use of proceeds of the offering
  • Information on the issuer’s progress toward meeting its funding goals

Rule 506(c) Verification Requirements 

This is a very minor change that is helpful for anyone who does more than one offering under Rule 506(c) which requires you to take reasonable steps to verify that all of your investors are accredited.  If you do more than one 506(c) offering in a 5-year period and someone from the first offering wants to invest in the second offering, you don’t have to re-verify their status as accredited as long as they provide a written representation that they continue to qualify as an accredited investor and you are not aware of information to the contrary.  

Harmonization of Disclosure Requirements 

Participation of Unaccredited Investors in a 506(b) Offering:  Under the current rules, you are allowed to have up to 35 unaccredited investors in a Rule 506(b) offering.  In practice, very few businesses allowed any unaccredited investors in these offerings because the disclosure requirements are increased if you make the offering to even a single unaccredited investor and the disclosure requirements include an audited balance sheet which most businesses don’t have.  Under the new rules, if you are raising up to $30 million under Rule 506(b), you will no longer need to provide an audited balance sheet, although the disclosure requirements are still relatively extensive.

Proposed Amendments to Simplify Compliance with Regulation A:  These are a handful of technical rule changes to make Reg A filings easier.  They address things like whether you are allowed to redact sensitive information from contracts included in Reg A filings and simplification of other filing requirements.

Offering and Investment Limits

Reg A:  The maximum offering amount under Tier 2 of Reg A is being increased to $75 mill.  The maximum offering amount for secondary sales under Tier 2 of Regulation A is being increased from $15 million to $22.5 million.

Rule 504:  The offering limit is being increased from $5 million to $10 million. 

Reg CF:  The offering limit is being increased from $1.07 million to $5 million. Investment limits no longer apply to accredited investors—in other words there is no cap on how much an accredited investor can invest in a Regulation Crowdfunding offering. Unaccredited investors may rely on the greater of their income or net worth in calculating their investment limit (under the current rule they had to rely on the lower number). 

Crowdfunding Vehicles

The new rules authorize a new type of entity called a “crowdfunding vehicle.”  This is a special type of entity that can be used when a company conducting a raise under Regulation Crowdfunding wants to avoid having all of its crowdfunding investors having a direct investment in the issuer.  The issuer can form a crowdfunding vehicle and the investors invest in the vehicle rather than the issuer.  The vehicle then becomes the owner of the securities in the issuer.

5-Day Challenge:  Create a Golden Opportunity for Investors

5-Day Challenge: Create a Golden Opportunity for Investors

We just wrapped up a LIVE 5-day challenge—Create a Golden Opportunity for Investors: How to Design a Win-Win Investment Offering.

It was awesome! Hundreds of people joined the challenge where we taught how to design a customized investment offering.  Here’s what they learned:

Day 1—We talked about why it’s so important to design your own offering and how to lay the groundwork to ensure you design the right offering for you.

Day 2—We went over the three basic types of investment offering and how to choose which one you want to offer.

Day 3—We explored how your investors can get paid—spoiler alert: you don’t have to grow fast and hustle for a fast exit!

Day 4—We reviewed the pros and cons of giving investors any control and what that can look like. We also talked about tools to motivate faster and larger investments.

Day 5—We pulled it all together and talked about how designing your offering fits into the larger strategy for raising the right money from the right investors—in a way that lets you stay true to your mission and goals.

It’s not too late to check out the training! The videos and worksheets are still available for FREE for a limited time. Get immediate access to the challenge—start today by signing up here.