Writing on his blog The Next Big Thing, Google developer advocate Don Dodge explains some factors that drive angel investors. Angels love to help start companies, solve tough problems, build a great team, and be actively involved in finding customers, partners, and key employees, he says. They tend to invest in companies that are within a one-hour drive so they can be actively involved and leverage their network of friends and business associates. If they can’t be actively involved in a company, they probably will not invest.
Angels tend to invest like VCs except with smaller amounts — $200K to $2M — and typically complete 15 times as many deals, Dodge adds. The average angel group makes eight investments per year, totaling about $2M, with an average deal size (seed stage) of about $250K. “Angels are compassionate and have a soft spot for budding entrepreneurs, but they are not stupid,” Dodge writes. “They invest in what they know, where they can apply their experience, and in deals where their money can have impact.”
Because they invest at the seed stage, some angels use convertible notes to fund companies. Rather than haggle about valuation, angels will sometimes invest early and agree to convert their note at the price set by Series A investors. “The theory is that, at Series A, more will be known about the business, market, competition, and technology, and it will be easier for the founders and investors to agree on a valuation,” Dodge explains. In addition, convertible notes usually have simple terms and fixed interest rates, and may include warrants to purchase additional shares. Convertible notes can be assembled quickly by a lawyer for a small fee, while Series A docs are complicated, expensive, and time consuming. “If you are only raising $100K of seed money it doesn’t make sense to spend $25K to $50K on lawyer’s fees for Series A docs,” Dodge points out.
When everything goes according to plan, convertible notes are fine, but there are risks for angels. “The problems come when it takes much longer to raise the Series A, or you never raise a Series A,” Dodge says. For example, if an angel invests with the expectation that there will be a Series A within four to six months at a valuation somewhere around $2M, what happens if a year or more passes, the company excels, and the valuation goes to $6M without an A-round? The angel took all the risk, helped build the company, and waited a year or more yet gets none of the benefit of helping to build the company valuation, he points out. If the company is acquired for $10M or more before a Series A, the angel loses that value creation. In fact, the company may never raise a Series A if it fails, becomes cash flow positive and doesn’t need to raise money, or is acquired.
Having specific conversion values for each of these scenarios can solve these problems, Dodge says. For example, the note could stipulate, “If Series A is raised within six months, the notes convert at the same price as Series A investors. If Series A takes longer than six months, the notes convert at a valuation of $2M, regardless of the Series A valuation. If acquisition occurs within six months and prior to Series A, the notes convert at the lesser of $4M or the acquisition valuation.” The goal is to allow angel investors to participate in upside value creation in exchange for taking early risk and helping to build the company.
Source: The Next Big Thing