Angel Investors Protection

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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)

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

Sources
Sources

Quotes
  • "Through a SAFE (Simple Agreement for Future Equity), first developed by Y Combinator. SAFEs are intended to be an alternative to convertible notes, but they are not debt instruments—unlike a note, a SAFE has no maturity and does not bear interest."
Quotes
  • "Weighted-Average Anti Dilution – This is a far more complicated adjustment method. It seeks to protect the investor without completely avoiding dilution. It bases the amount of investor dilution on the total number of new shares issued and the price of the issuance. The best way to explain the adjustment is to present the applicable formula."
  • "Full Ratchet Anti Dilution – This adjustment method provides 100% dilution protection to the investor. It does this by adjusting the conversion ratio so that the denominator is the price paid for stock in the later issuance."
Quotes
  • "The concept of a ratchet is that, as your company’s valuation has fallen, to preserve your investor’s value his ownership percentage must increase. Usually, that involves giving the investor extra shares or, where the investor’s existing shares are convertible, increasing the rate at which they convert into ordinary or common shares. Either way, the calculation of the extra shares is key as this has the potential to be extremely dilutive to the founders."
  • "The alternative is a “weighted average” calculation, which factors in the size of the down round relative to the company’s total share capital and will produce a per-share price somewhere between the down-round price and the price the original investor paid. The weighted average can be “broad-based,” which means that shares under options, warrants, convertibles etc. are factored into the share capital calculation, or “narrow-based” if they’re not. "
Quotes
  • "Getting the first purchase choice With this portion of the provision, the investor is given the right to make the first offer on the business if it were up for sale. No outside parties can make an offer before the investor does for a certain amount of time. This gives them more security as well because they will ahve the first opportunity to jump on the purchase of a business they are already invested in."
  • "All of these components of the pay to play provision are very important in attracting quality investors. People who are serious about their investing tactics will take a company seriously if these are added into the provision. Often, they look specifically for these items, the anti-dilution clause, the right of first offer clause, and the preemptive right clause, as a way to protect as well as grow their money."