You’ll get more out of this series if you’ve read part 1 (high-level angel investing guidelines), part 2 (debt, equity, and key terms), part 3 (company stages), part 4 (deal flow), part 5 (good founder qualities and red flags), part 6 (market and due diligence), part 7 (filtering, day-to-day, and syndicates), and part 8 (exits).
Let’s tie it all together with an example.
You’re an angel leading a syndicate on AngelList. A company raises a $750k pre-seed round on a convertible note. A VC firm, Pre-Seed Capital, leads the round, putting in $500k. Your syndicate puts in $100k, of which $10k came from you personally and $90k came from your backers. Smaller angels fill out the additional $150k in the round.
Because Pre-Seed Capital led the round, they provided the terms of the convertible note. You signed the same note. Key terms: $4M cap, 20% discount, investors all get preferred shares upon a conversion (which include pro rata rights), and the note converts to preferred equity if the company raises a following round of at least $1M.
One year later, the company raises a priced seed round led by Seed Capital of $3M on a $14M pre-money valuation. This is a post-money valuation of $17M (amount raised + pre-money valuation). Seed Capital’s term sheet includes a provision that gives them and the note holders preferred shares in the financing. This round size counts as a triggering event to convert the note holders’ debt into equity. Your syndicate’s $100k converts into equity, specifically to preferred shares. You can either convert using the $4M cap or get a 20% discount on the $14M pre-money valuation, which is $11.2M. Clearly you choose the $4M cap, because it means your $100k gets you a higher ownership percentage. Dividing your $100k investment by the $4M cap gives you 2.5% ownership. Your $100k is now worth $350k (2.5% of the $14M pre-money valuation). Note that this conversion happens before the raise, which is typically defined in the terms, so your syndicate has 2.5% of the company entering the seed round where $3M in new money is coming in.
If you exercised your pro rata before the round, you’d have the right to put in up to 2.5% of the $3M raised, or $75k. Note that most angels don’t do their pro ratas, so we’ll say that you don’t do yours.
So your syndicate converts before the seed round to 2.5% ownership of the $14M pre-money valuation, or $350k. Then the $3M round happens, and you aren’t exercising your pro rata. Dividing your ownership value by the post-money valuation ($350k divided by $17M) gives you 2.05% ownership after the round. That’s dilution at work.
Two years go by and things are going great, so the company goes out to raise a Series A. They close a round led by Series A Capital of $8M on a $30M pre-money valuation (a $38M post-money valuation). Series A Capital gets a new class of preferred shares, so although both the seed round investors and the new Series A investor have preferred shares, the Series A investor’s shares are senior to the seed investors’.
Going into the Series A round, your 2.05% is worth $615k (2.05% of the pre-money valuation of $30M). Because of your pro rata, you have the right to put in up to 2.05% of the round raised (so 2.05% of $8M, or ~$164k). Again, you choose not to. This leaves you with $615k of the $38M post-money valuation, or 1.6%. Note that more dilution has happened. Unless you exercise your pro rata right to preserve your ownership, it’ll happen with every round. Now that your syndicate is sitting on a value of $615k, you have a 6.15x multiple on your $100k.
OUTCOME 1: everyone loses
Two years ago by and things aren’t going well for the company. They haven’t hit the milestones they set out to achieve in the seed round, the employees are unhappy and starting to quit, the founders haven’t been able to raise a bridge round, and they only have one month of runway left. They can’t salvage the company and end up shutting down.
In this scenario, everyone loses their investment. Your syndicate is out $100k.
OUTCOME 2: some people lose
The company has a month of runway and is getting desperate, so they decide that the best possible outcome they have available is to sell their intellectual property. The acquirer is buying the technology and isn’t putting a high premium on the company’s other assets, such as the team. Thus their offer price is fairly low. The company raised $11M total ($3M in the seed and $8M in the Series A), but sells for $5M.
Because the company sold for less than what it raised, only the senior preferred shareholder (Series A Capital) makes back some of its investment. All of the $5M goes toward paying back that senior preferred shareholder, and they still have a loss of $3M in the end. Then there’s nothing left to pay the junior preferred shareholders (Seed Capital and the angels), or the holders of common stock (the founders and employees), because all of the proceeds are gone by the time the waterfall gets to them. Thus your syndicate loses its entire $100k.
OUTCOME 3: everyone wins
The company never raises any more money after the Series A round and sells for $200M a few years later. Because it sold for more than it raised, everyone’s shares convert to common. Your $100k syndicate has 1.6% of the company, so it gets 1.6% of the $200M selling price, or $3.2M. That’s a 32x multiple on the original $100k that your syndicate invested.
Let’s break it down further to show the extra leverage that you get by leading a syndicate:
Total syndicate profit is $3.2M (32x multiple).
Your personal $10k that you invested as syndicate lead is now worth $320k.
Your $90k syndicate, composed of your backers, has made $2.88M. That gets distributed among your backers based on how much each individual put in.
5% of the $2.88M profit, or $144k, goes to AngelList as their platform fee.
You get 15% carry on your syndicate deals. That 15% comes out of the $2.88M profit that your backers receive, which ends up as $432k.
So your $10k becomes $320k through the standard 32x multiple, which is already great, but then you get an additional $432k through your carry. Thus you end up with $752k, which is a 75.2x multiple on your $10k by taking the lead and running a syndicate that ended up successful.
Glossary
This isn’t an exhaustive list of every term you’ll encounter in angel investing, but they’re the most common.
Accreditation- An investor is “accredited” according to the SEC if she either A), has a personal net worth of over $1M, not including real estate (it’s unclear whether stock you hold counts toward your net worth), or B), has made a salary of over $200k over the past two years individually, or over $300k over the past two years jointly with a spouse. Technically you have to be accredited to make angel investments, although those requirements become fuzzier when you’re investing other people’s money. Accreditation is designed to protect investors from investing money that they aren’t wealthy enough to afford to lose, and does not take into account how knowledgeable or experienced investors are.
Common stock- A class of stock belonging to the founders and the employees of a startup. The most basic unit of equity ownership.
Convertible note or debt- A form of short-term debt that converts into equity, typically in conjunction with a future financing round; in effect, the investor is loaning money to a startup and instead of a return in the form of principal plus interest, the investor expects to get equity in the company.
Debt- A loan from investors that is never meant to be paid back. It is intended to convert into stock at a future date, based on some to-be-determined price. It assumes that you’re investing in a fast-growing company that will raise subsequent financing rounds quickly.
Dilution- As companies grow and become more valuable, they take in more outside funding. The new investors take equity in the company, reducing the amount that current shareholders own. If a new investor buys 20% of the company, the existing shareholders get diluted 20%. Even though founders generally want to avoid dilution, it’s inevitable and it means they have a smaller piece of a more valuable whole.
Equity- Stock and an ownership stake in a company. An ownership position.
Equity round / priced round- An offering and sale of newly-created stock in a company at an agreed-upon per share price.
Post-money valuation- The value of a company after a fundraising round, calculated by adding the amount raised to the pre-money valuation.
Preferred shareholder- A class of shareholders that have greater claim to the company’s assets than common stockholders and have additional rights. They are first in line to collect a payout if an exit that’s lower than the company’s valuation occurs (i.e., bankruptcy or mergers/acquisitions).
Pre-money valuation- The value of a company before a fundraising round.
Pro rata- A right to invest more capital to preserve your ownership stake in a company as it raises additional rounds.
SAFE- Stands for Simple Agreement for Future Equity. A simple mechanism to make an investment in an early-stage startup. With a SAFE, you are buying the right to buy into a future equity round at a cheaper price.
Term sheet- An agreement in principle that outlines the terms of an investment deal. It is not a contract or a promise to invest, and thus is not binding and does not mean that the investment deal is completed. Think of it as a signal that investors are interested. Some investors only offer term sheets if they’re committed and certain they want to invest (like us at Accomplice); others offer term sheets more freely.
Books for further reading
I’m a book person when it comes to learning, and I found these very helpful. Note that some are several years old and their descriptions of average round sizes and other investing trends are slightly out of date, but it doesn’t matter much.
The Venture Hacks Bible, by Nivi and Naval Ravikant, the founders of AngelList. 1000+ pages and worth every minute. Get it for free here.
The Founders Pocket Guide series by Stephen R. Poland. These are short (80–150 page) books each covering an aspect of angel investing, like Term Sheets and Preferred Shares and Cap Tables.
Venture Deals by Brad Feld. This is canon.
The Business of Venture Capital by Mahendra Ramsinghani. Although you aren’t a VC, it’s useful to understand where they’re coming from. Part of your value-add is often to help the founders raise later rounds from VCs.
Thanks for reading. I hope this guide was helpful. Given that my aim was to demystify the basics of angel investing, I know I didn’t cover everything. That said, did I miss anything key? Please let me know at sarah(at)accomplice(dot)co and @SarahADowney on twitter.