#Structuring: 4th Fundamental of Early-Stage Investing
When it comes to structuring, angel investors need to be very strategic in how they use this fundamental in choosing which investment to follow through with because structuring deals with the critical aspects of how the early start-up optimizes the delivery of operations, ownership, control, and risk.
This fundamental, as highlighted in “Winning Angels, the 7 Fundamentals of Early Stage Investing,” helps in dealing effectively with the interest of the start-up and the investor simultaneously because it has a way of highlighting how wisely the investor’s objectives are achieved.
While the preceding fundamental of valuing helps an angel investor determine the worth of the start-up in a way that supports the structuring decision regarding the terms of the deal, level of risk, and potential returns on investments. Structuring takes care of the interests of the angel investor by showing that the entrepreneur has built a robust and stable business with a high potential for success.
As identified by the authors, there are two broad concepts concerning early-stage transaction structuring:
The one emphasizing maximizing the investment’s upside and the one favoring protecting the investors’ downside. These two schools of thought are described as ‘the simple’ and ‘the complicated.’
With the simple deal format, everything is straightforward. It is a simple equity investment, with the angel receiving a specific number of firm shares in return for their contribution. This is the format I recently engaged in with a couple of co-investors (this approach gives the flexibility of having a token of the investment regardless of how small the investment is). The complicated structure offers angel investors more power over the business, including more significant returns on investments that may include convertible notes, warrants, or other features.
Further highlights include the need for investors to understand key contract clauses while reviewing investment decisions, including valuation, ownership proportion, liquidation preferences, anti-dilution safeguards, governance rights, vesting, and exit rights.
The authors touched on the possibility that an investment may need more financing, such that it can create opportunities for future investment rounds. Recently, an investment group (of which I am a member) held a second round for a high-potential early-stage start-up. The start-up had come to update investors on progress and decided to open up more equity for investment because they wanted to allow investors to exit (If they so desired). When this start-up first came to the ‘investment table,’ many investors were skeptical about investing due to the volatility and risk associated with the industry. However, a 250% increase in returns and potential growth indices had many who did not make the initial round ‘jump on board.’
The author also takes time to point out the critical role of venture capitalists (VC). The VC is meant to serve as an expert investor with the financial capacity to invest more money for more extended periods while also holding the professional prowess of being able to advise those who have little knowledge about the dynamics of angel investing. Today, many venture capitalists have been known to start groups that support entrepreneurs and investors alike.
While the authors present the benefits structuring can give when investing in a start-up, it helps in providing a partial overview of the potential success a start-up may have; it can also be limited when it comes to making changes later, especially if there is a need to alter existing structure. While every angel investor is focused on picking out the best deals to deliver significant investment returns, it can be challenging!
However, the authors iterate on what it takes for an investor to win by focusing on value creation, supporting entrepreneurs, and seeking to make a difference in the lives of each start-up. Winning may be a short-lived concept because it is ultimately about the long-term perspective, which often involves considering every single stake involved.
Despite the good that structuring provides when finalizing the deal to invest in, a divergent perspective is that structuring needs to consider other critical aspects, including the flexibility and dynamism of the adopted structuring model or strategy, which may view, market conditions- including the volatility of the industry and its competitive landscape. These can be considered essential because complications arise that are never within the control of the start-up, e.g., political instability, socio-economic conditions (as it exists with emerging economies within Africa where potentials are high but uncertainty is also very high), including epidemics/pandemics such as the one experienced during COVID-19, as well as other external unseen change factors with the capability to impact the viability and success of the start-up despite well-structured agreements.
Every investor is in the game to win, and it takes patience, a consistent learning attitude, and a growth mindset to harness the benefits of having a promising and well-structured start-up.
Winning as an angel investor comes with challenges that are surmountable over time. However, as highlighted in the text, having a long-term perspective holds benefits for an angel investor, including giving an angel investor time to exit strategically, maximizing returns on investment by selling equity stake when the start-up reaches a favorable valuation, or achieving a significant milestone.
Though structuring indicates carefully considering how the start-up company will work, it still has drawbacks. As such, it is critical to have a holistic approach to finalizing any investment decision.
Resources
Amis, D., & Stevenson, H. (2001). Winning Angels, “The Seven fundamentals of Early stage investing. Pearson Education Limited. Print.
Dolapo,
I seriously appreciate your reflections on our reading. Truthfully, I continue to find them more digestible than the text! It’s difficult for me to give any notes or commentary on this post, as I feel like this is a wonderful overview and summary of the structuring process and all the key factors that contribute.
As an (aspiring) entre/intrapreneur, this post is a useful tool to help one understand both the “simple” and “complicated” structuring approaches, explored by the authors of Winning Angels.
Again, thank you for taking our source material and making so approachable!
-Amanda
Dolapo,
In your post on structuring, you highlighted the two broad concepts concerning early-stage transaction structuring described as ‘the simple’ and ‘the complicated.’ To expand on your thoughts, each approach has its own set of advantages and drawbacks, and the choice often depends on the specific circumstances of the deal.
The Simple Approach
The Simple Approach involves fewer components. Effective by using simple instruments like convertible notes or equity. Convertible notes are loans that convert into equity when the company raises a subsequent round of financing. And straight equity investments are also simple – the investor receives shares in the company in exchange for their investment. The advantage of the simple approach is that it allows the entrepreneur and investor to close the deal with lower legal costs.
The Complicated Approach
The Complicated Approach: Involves more complex instruments including SAFE notes (Simple Agreement for Future Equity), KISS (Keep It Simple Securities), or Series Seed Preferred Stock. These come into play when the deal involves larger sums of money, multiple investors, or specific contingencies. The complicated approach may involve more negotiation and higher legal costs, but it can provide more protection for the investor and greater flexibility in structuring the deal.
• SAFE notes are instruments that convert into equity in a future financing round but, unlike convertible notes, they are not loans and thus do not accrue interest or have a maturity date.
• KISS is like SAFE but can act both as a debt or equity instrument, depending on the terms of the agreement.
• Series Seed Preferred Stock is a simple equity structure that gives investors preferred stock, which has certain privileges over common stock, such as dividends or liquidation preferences.
In both approaches, it is critical for both parties to fully understand the implications of the chosen structure. Both parties must feel comfortable with the chosen approach, which should align with their risk tolerance, the company’s stage and future financing plans, and the dynamics of the specific investor-entrepreneur relationship.
Hi Robert,
It is always an honor to read your comments because they come from a place of deep experience. It will be my pleasure to learn more from you.
Appreciate your input it is always insightful.
Dolapo
Dolapo, your posts are always a pleasure to read and I find myself better understanding book material when I read your posts. Structuring opened my eyes to the point that once an investor develops a clear and outlined foundation, the deal will be much easier to maneuvre through any uncertainties that may rise. Having a structure helps both the entrepreneur and the investor see the direction laid out in front of them and minimize any confusion. Or at least that is what a clear and simple structure should achieve. Your sentence in paragraph three is the highlight when you say, “Structuring takes care of the interests of the angel investor by showing that the entrepreneur has built a robust and stable business with a high potential for success”. I couldn’t agree more.
Great post!