Angel Investors Protection
Angel investors can use a simple agreement for future equity (SAFE), ratchet anti-dilution protection, weighted average anti-dilution protection, pay to play provision, and a convertible promissory note to protect themselves from unfair dilution of their investment. Detailed below is more information about each of these legal strategies.
SIMPLE AGREEMENT FOR FUTURE EQUITY (SAFE)
- Investors can protect themselves against unfair dilution of their investment using a simple agreement for future equity (SAFE).
- SAFE entails investors providing cash for a company and waiting until the next round of financing to convert the cash into shares.
- Investors employ SAFE for companies that are in their earliest stages of growth to ensure they get a more accurate valuation of the shares in later days.
- SAFE does not have a maturity date or bear any interest.
RATCHET ANTI-DILUTION PROTECTION
- A ratchet protects 100% of the investor's investment in case the value of the company falls during a down round.
- The provision is usually employed by giving angel investors more shares for their ownership percentage in the company to remain the same even if the value per share has decreased.
- One way this is done is using a full ratchet calculation that gives the investor new shares for his total investment based on the share prices at the down round.
WEIGHTED AVERAGE ANTI-DILUTION PROTECTION
- This provision ensures that the investor does not lose his initial investment if later rounds of financing are offered at a lower price per share.
- Weighted average protection is successfully employed by considering the total number of shares issued and the price they were issued at instead of using the same share price that is being used at the down round like in ratchet protection.
- An angel investor can use weighted average protection where additional shares will be awarded to him factoring the size of the down round relative to the company’s total share capital.
- Weighted average protection can be divided into broad-based weighted average or narrow weighted average dilution. Broad-based weighted average factors in shares under options, warrants, and convertibles, while narrow weighted average dilution protection does not factor any of the mentioned shares.
PAY TO PLAY PROVISION
- Investors can also protect themselves by using a right of first offer and pay to play provision.
- A right of first offer allows an investor to use a preemptive right to be the first to purchase additional shares up for sale in the company to increase or maintain ownership in the company. Also, it prevents any outside parties on making any offers on the company's shares, if any are up for sale, before them.
- An investor employs this strategy if he believes the value of the shares will eventually go up; and therefore, they should have the right to be the first to indulge in the company's success before anyone else does.
CONVERTIBLE PROMISSORY NOTE
- An angel investor can protect against unfair dilution of their investment using a convertible promissory note.
- With this legal strategy, the investor is given a note by the company promising to convert the note into shares during the next round of financing for the company.
- The note usually has a maturity date of twelve months; and it bears interest, giving the investor the best chance to avoid dilution and earn a profit during the next round of financing.