Investment Vehicle	Brief Definition
Preferred Stock (voting)	The most common equity investment vehicle used by both sophisticated angel investors and venture capitalists. Preferred stock has rights, preferences, and privileges greater than other types of equity investment. Two important preferences are the entitlement of preferred stock to receive dividends before common stock, and the entitlement of preferred stock to receive a return before common stock.
Preferred Stock (nonvoting)	Gives the same privileges upon liquidation, but does not allow the angel investor to vote shares on important corporate matters, for members of the board of directors, and so on, though certain protective provisions may still allow voting on matters with potential impact on the investor.
Common Stock (voting)	The most basic form of security a corporation can offer. It essentially places the investor on the same financial footing as the founders of the company. This form of investing is generally considered unsophisticated, but still occurs among angel investors. However, some sophisticated angels take common stock because they want to have the same risks as the founders. Also, companies sometimes refuse to offer preferred stock, so common stock is the only type of equity available.
Common Stock (nonvoting)	Same preference as the founders in liquidation, dividends, and so on, but without the ability to vote shares on important corporate matters, for members of the board of directors, and so on.
Warrant	Entitles the holder to buy a proportionate amount of stock at some future time for a predetermined amount, and can be used with an investment for equity or debt. Warrants are generally used as an incentive or sweetener to invest in a company. While warrants are typically for common stock, occasionally a company will use a warrant for preferred stock as part of an investment package.
Option (for common stock)	A right to purchase stock at a predefined value; not a typical investment vehicle for angels. Stock options are typically provided to employees, board members, consultants, and others as a form of reward or alternative form of compensation for past, present, or future services. One circumstance in which options may be granted to an investor would be as an additional benefit or inducement for investing, though warrants are typically the vehicle of choice in these circumstances.
Debenture (promissory note; not convertible—straight debt)	A note carrying interest payable in cash or stock. Investors may insist the note be collateralized (secured), which will make a difference for the investor if the company fails.
Debenture (promissory note; convertible into common or preferred stock)	A debt instrument that automatically converts into equity upon the occurrence of an event or milestone, or at the investor’s discretion, or sometimes in either event. Some angels prefer to use a convertible debenture to take advantage of subsequent investment round terms, avoid negotiating valuations, and always have a debt obligation should the conversion fail to occur. This kind of instrument will typically convert to preferred stock.
Stock or Debenture Investment (with associated options or warrants)	Debt instrument with associated options or warrants that provides the investor with an incentive or added benefit for making a risky investment in a start-up company.
Guarantor (on line of credit or other debt instrument)	Assurance that the angel will assume the holder’s position should the entrepreneur default on the debt instrument through nonpayment of the outstanding debt balance.
* Note: The table is somewhat simplified and does not include discussion of numerous additional terms and conditions related to various investment forms, such as voting agreements, security agreements, buy-back agreements, co-sale and rights of first refusal, and other rights, preferences, and privileges.

BASIC DIFFERENCES BETWEEN DEBT AND EQUITY INVESTMENTS

Debt carries an obligation of repayment. That is, the fundamental difference between debt and equity is that debts must be repaid at some point, generally described at the maturity date, while equity investments need not be repaid. Of course, assorted nuances and additional terms can modify this simplified definition. For instance, a debt instrument, typically a promissory note, can have terms that automatically convert the debt into equity upon the occurrence of a predefined event or milestone. Appendix 8 is a simple convertible debenture (or note) that contains a clause allowing for the automatic conversion of the debenture into preferred stock upon the company raising $3 million dollars. The debenture also allows the holder (an angel investor in this case) to convert it into equity at any time at a preset price per share; rarely is the right of conversion left to the discretion of the company. As the annotations in Appendix 8 explain, convertible promissory notes can have a variety of structures and terms related to conversion price, rate, timing, and other factors.

Interest is typically due on promissory notes and many investors will agree to accept interest payments in the form of stock (typically common stock) rather than cash. For any entrepreneur, cash is precious; most angel investors would prefer you use 100 percent of your cash to grow your company rather than paying interest on their debt. The issuance of convertible debentures for a short period before a preferred stock offering round of financing is called bridge financing. It results only in a minor amount of cumulated interest, so it is generally accepted by most investors.

Convertible debentures such as warrants and convertible promissory notes are the investment vehicle of choice for many angel investors because they are relatively straightforward. The angel investor agrees to automatically convert the debenture into a preferred stock offering for a discount off the price offered to other interested parties. Often the preferred stock financing will be negotiated by a venture capitalist or a group of angel investors, giving the investors a definitive advantage in negotiating investment terms. The original angel investor holding the convertible debenture then receives the investor-favorable terms negotiated in this next round and the entrepreneur has the financing needed to grow the company to a point when a venture capitalist would be interested in investing. The convertible debenture also provides this early-stage, high-risk investor with some security: if the company is unable to raise the next round of financing, the investor still holds a debt instrument that requires repayment upon maturity. This obligation of repayment, while possibly an illusion considering the typical strained coffers of a start-up company, does place the investor in a senior position to the founders and stockholders upon liquidation or dissolution of the company.

One side note: debt-heavy balance sheets, even with convertible debt, can result in difficulties concerning future financing, particularly with venture capitalists. Subsequent investors are not interested in seeing their money go to pay off an investor or shareholder—they want every penny applied to business growth and expansion. Therefore, in subsequent rounds investors will often insist that all debt be converted into equity, even straight debt.

Equity provides higher potential return but carries greater risk of loss. As noted, debt and equity investments differ over the lack of a legal obligation for repayment with the latter. Exceptions or caveats to this statement exist, for instance if the shareholders enter into an agreement obligating the company to repurchase shares at some time in the future. Also, redemption rights or the right to force the company to repurchase shares as a term of a stock offering (almost always preferred stock) would be considered a legal obligation for repayment. Nonetheless, investors approach a stock investment differently from a debt, both psychologically and in terms of benefit expectations. Because of the greater risk of loss, investors often take longer to make an equity investment decision and often require more information in the due diligence process. In addition, because of the higher level of risk, investors expect to receive a greater potential benefit. Preferred stock provides additional rights, preferences, and privileges to create at least a perceived balance for the investor between benefit and loss. Based on this reasoning, equity investments are best for high-growth potential ventures, since debt instruments (unless convertible) have a predefined cap on gain through interest payments (and perhaps some additional stock in the form of a warrant). In contrast, equity investments can achieve major multiples, sometimes returning ten or twenty times the investment—or more, on huge successes. You’ve surely seen the occasional news clip about angels and other early-stage investors putting in $100,000 that is now worth $10,000,000, which is why many angels get in the business in the first place.

From your perspective as the entrepreneur, equity investing has a lower financial risk since it generally does not carry an obligation of cash payments (except perhaps for mandatory dividend payments), whereas debt servicing will entail interest and principal payments. Also, some debt financing methods, such as lines of credit, have restrictive covenants that could cause you to default. Pure equity investments do not have default conditions unless the investor has a put option (right to demand repayment of equity investment after a set time period) or some other future obligation that creates a liability; however, put options and other obligations are not the typical equity investment.

Of course, nothing is perfect. Equity investments do have downsides. Because the risk of loss is higher for investors with an equity investment, investments can take three to six months from introduction to check in the bank. You may not have enough cash to last that long, so while you have a few options, the experienced entrepreneur must keep ahead of funding needs and avoid getting to a zero bank balance. This cash-over-time requirement is often termed “adequate runway,” referring to the length of runway a plane will need to land safely—or cash for a company to get to profitability—with different lengths needed for a two-seater and a jumbo jet.

Another downside to equity investing is ownership dilution for the founders, employees, and existing investors. Equity investors reduce your voting control, unless your investors agree to take nonvoting stock, which is quite unlikely. Equity investments can also reduce your management control, though this happens more often with venture capitalists than with angel investors. Venture capitalists will often require one or more seats on the board. This board structure often means greater involvement in management and certainly in strategic direction.

Angel investors often choose to have only information rights (the right to receive information on the company through various communication sources such as quarterly reports, monthly financials, annual report, business plans, and the like), rather than taking a seat on the board. Angels tend to avoid board seats—partly because they normally have a number of investments in their portfolios to provide appropriate diversification, and so do not have the time to serve on all their investments’ boards. In addition, angels answer only to themselves, unlike venture capitalists, who have limited partners to whom they owe the fiduciary and financial duties of minimizing risk and maximizing potential returns. Venture capitalists typically invest significantly more than angels and as a result have a greater stake in the company. Meanwhile, Sarbanes-Oxley has caused angels to shy away from serving on boards and thereby raising their perceived liability exposure.

If you must retain 100 percent control indefinitely, it may mean forgoing growth or struggling along with limits on potential financing. If you feel you need control in the short term, then convertible debentures may be a solution to your funding needs. While convertible debenture is considered equity for purposes of your capitalization structure and balance sheet, it does not have voting rights for the underlying shares. Only upon conversion can the holder exercise the voting rights for the stock, which postpones investors’ control to a future time.

Another factor to consider in deciding between debt and equity is prioritization upon liquidation—that is, how assets or sale proceeds will be allocated if the company goes out of business and distributes its remaining assets. The general priority of payment works like this:

• First repayment to secured and collateralized debt—senior position

• Second repayment to secured and collateralized debt—junior or subordinated position

• Third repayment to unsecured and noncollateralized debt (any of this debt being straight debt or convertible)

• Fourth repayment to preferred stock—which can be issued in a number of series

• Finally, repayment to common stock—that is, founder stock, employee stock, most friends and family, and some angels

If a company is closing its doors, the likelihood that common stock shareholders will receive payment if all these prior categories exist is slim at best. Note that options and warrants are not listed; until exercised, these represent only the right to purchase stock, not the actual underlying stock itself.

Based on all this information about debt and equity investing, the best advice in deciding your course of financing is to weigh the relative pros and cons of debt verses equity investing, understand your financial needs now and into the future, and know your investor market and their preferences.

PREFERRED STOCK

Preferred stock, quite simply, is stock that has additional rights, preferences, and privileges beyond common stock. Preferred stock is the most popular investment vehicle for sophisticated angel investors because of these rights, which include the preference upon liquidation I just mentioned. Holders of preferred stock also have priority on dividends, rights to control certain corporate actions, and the privilege of choosing to receive a distribution as a preferred stock shareholder or converting the holdings into common stock if financially more advantageous, such as upon an initial public offering. Convertible debentures usually convert into preferred stock with the first preferred stock investment round. Preferred stock is often issued in series, with each series typically having sequential alphabetical identifiers, so the first series or round of preferred stock financing is Series A, the second round is Series B, and so on. In theory, each subsequent round or series should be for a higher valuation.

If your company will need one or more substantial rounds of financing after the angel financing round, simpler early round terms are best. An overly complicated term sheet in an early round can either suppress interest among potential subsequent investors or lead to demands from subsequent investors that early investors accept modified investment terms. Savvy angel investors understand this investment truism: The last gold rules. In other words, the most recent money being invested in a company controls overall terms, even for other rounds. Why? Because subsequent rounds are typically larger than their predecessors, representing a greater potential share of company ownership, and consequently they have greater influence. But most important, without the new round of financing, the company will tank—causing previous investors to lose their investment. So what should the earlier investor do? Stand hard on terms that subsequent investors find unacceptable, or accept compromises and see the company continue to grow? You can hope your investors would see the latter as the obvious choice, but unfortunately not all are that perceptive. This means you, as the entrepreneur, need to have a good understanding of investment options and terms. Several forms of angel investment have been introduced, with convertible debentures and preferred stock structures being two frequently used investment vehicles.

When a subsequent round of financing purchases ownership at a lower value than the prior round, it washes out the ownership percentage of earlier investors, along with the founders, employees, and other holders of common stock. This is called a “down round” and is a common fear among investors who have common stock, and another reason angel investors and venture capitalists favor preferred stock. To better understand the concept of a down round, look at Table 3.2, and also the definition of “Cram Down” in the Glossary, Appendix 1.

Compare Table 3.2 with Table 3.3. The only difference between Table 3.2 (the cram down) and Table 3.3 (normal progression investments) is the price paid per share for the Series B preferred stock. Both rounds show a Series B round raise of $3,000,000, but with the cram down round at $0.50 per share for the Series B and previous Series A round raise at $1.00, while the normal progression round is at $1.00 per share for the Series B and the previous A round at $0.50. Note the definitive difference in percentage ownership for the founders, angel investors, and employee option-holders.

Table 3.2 Capitalization Table Showing Cram Down (or Down Round)

Table 3.3 Capitalization Table Showing Increasing Valuation Rounds

Note the significant difference in ownership percentage for all shareholders (and option holders) depending on the valuation, and therefore, the price per share for each round. Protection against this type of negative impact and numerous other reasons, including the need to balance risk with reward, drive the terms of a preferred stock round. Approaches to financing differ in different regions, so you may encounter different preferences for multiples on liquidation and for the extent of protection rights.

Because of the frequent use of preferred stock offerings, the terms of such offerings should be well understood. Exhibit 3.1 provides a comprehensive listing and explanation of terms that may appear in a preferred stock offering. However, angel financing should be a scaleddown version if subsequent rounds of financing must be secured, particularly if those rounds will be venture capital. If a single round of financing will take the company to cash flow positive and to a level of financial confidence for intended growth, the angel round terms can be closer to those in the exhibit. Remember, this is only the term sheet that you should use to familiarize yourself with the construction of preferred stock agreements. Your legal counsel will utilize these or similar terms and conditions to create the final offering documents. The exhibit is set up to first show an example of language for a particular preferred stock term, followed by a discussion of the term. “Great Starts, Inc.” is a fictitious company used throughout this book for example purposes only.

Exhibit 3.1 Comprehensive Preferred Stock Term Sheet