The Right Way To Invest In A Startup

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A retired entrepreneur, who turned a $7 million company into a $60 million company and then sold it, joined a group of angel investors that meets once a month to review business plans for startup companies in their area.

Admittedly new at the game, the entrepreneur is seeking advice on how to play it the right way.

“Most of the startups we look at are ‘not ready for prime time,’ but at an entrepreneurship event sponsored by a local college, I became acquainted with a startup that I may want to help out, both personally with my time and contacts and financially with a reasonable amount of my money,” the entrepreneur wrote in a letter to me.  “Most of your columns are written from the startup’s perspective, but could you offer some advice to a first-time angel investor as to the right way to invest in these companies?”

First of all, congratulations on learning the first rule of angel investing: It isn’t just about the money. Most startup companies (especially those started by college or graduate students) need two things from investors that are worth much more than money in the long run:

  1. Expert advice that will keep them from making dumb mistakes; and
  2. A network of industry contacts that will help them negotiate key “strategic partner” alliances with distributors, vendors, advertisers and other players who will help the company stand out from the crowd and build up momentum.

Frankly, the satisfaction you get from helping these folks get off the ground can be worth far more than your return on investment.

Having said that, the money you’re investing is not exactly unimportant. You will need to review the company’s organizational documents (for a corporation, its articles of incorporation, bylaws and shareholders’ agreement) to see what rights you will and will not have as an investor.

Here are some things to look out for:

Voting vs. nonvoting shares 

Generally, angel investors have nonvoting shares in the company unless they are buying a huge chunk of the company. Nonvoting shareholders have few if any rights. Voting shareholders should not, however, have the right to impose obligations on the nonvoting shareholders (such as the obligation to make capital contributions) without the approval of the nonvoting shareholders. Make sure the company’s organizational documents give nonvoting owners a “veto power” over decisions that affect their interests.

Protection against dilution

As new investors put money into the company, your percentage ownership of the company will shrink. Normally, you don’t mind such dilution, as you are getting a smaller piece of a much bigger pie, but you should consider two ways to protect yourself against unfair dilution:

Anti-dilution provisions: These require the company to issue you additional shares to maintain your percentage ownership if the company raises capital in the future for a lower price per share than you paid.

Preemptive rights: These give you the right to purchase additional shares in any future offering, at the same price per share the new investors are paying.

Protection against clawbacks

Most startup company documents give the company a “right of first refusal” to buy your shares in case you die, become disabled, quit your relationship with the company or merely want to sell your shares to someone else after holding them for a reasonable period of time.

These clawbacks are not only appropriate, but also necessary for small businesses that expect to be managed by their owners for the foreseeable future. They are not as appropriate for nonvoting shareholders in fast-growing technology companies. You should be able to sell your shares to anyone you like as long as it’s legal and they do not compete with the company.

A seat on the board of directors

Having a seat on the board means you can look over management’s shoulders, mediate disputes between the founders and have a say on any important matter. But directors are also highly likely to be sued if something goes wrong. Unless the company is willing to pay for director and officer liability insurance – the annual premiums for which are usually $10,000 or more – I wouldn’t want to be on the board of directors.

Noncompete obligations

As both an investor and a consultant to the company’s founders, you will be handling lots of confidential information about the company. You should be expected to sign a nondisclosure agreement barring you from disclosing details about the company (even during those alcohol-fueled angel investor meetings) or using that information in any way detrimental to the company’s interests.

Noncompete obligations are another matter. You may want to invest in another company in the same industry, or you may want to do outside business with a company that has a relationship with your startup. Many startup documents contain nonsolicitation and noncompete clauses that may prevent you from doing so. Try to avoid signing them – or get something good in return for doing so.

You are an angel, after all. And angels aren’t stupid.