Angel Investors Protection

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Angel Investors Protection

While there is no direct information on legal strategies to protect early pre-seed/seed angel investors from later investors who might decide to alter the terms to their favor, convertible notes, control provisions, and pro-rata rights are clauses that would indirectly offer protection if properly applied. Below is an overview of the useful findings as well as an explanation of the methodology applied.

USEFUL FINDINGS

Convertible Notes

  • Convertible notes are investment instruments for a seed round financing that convert into preferred stock during subsequent investment rounds.
  • Ideally, when angel investors choose to use convertible notes, they are deferring the negotiation of their rights and interests to professional (Venture Capital) investors in the faith that they (VCs) would be incentivized by their huge investments to negotiate better terms.
  • Logically, this aligns the interests of angel investors with those of later investors which could offer protection from being unfairly pushed out.

Control Provisions

  • Control provision clauses warrants that any transactions be approved by investors or shareholders.
  • In essence, the clauses stipulates that investors must be informed before any changes in material leases or contracts, stock redemptions, capitalizations, and bylaws or charter, among others.
  • This gives angel investors a seat at the table when important decisions which may affect their stake in the company are being made.

Pro-Rata Rights

  • Pro-rata rights gives financing priority to initial/angel investors. It gives current investors the right to take part in any future financings.
  • Pro-rata rights enable angel investors to increase their stake in the company, if they are willing and able.
  • In practice, adoption of these clauses could offer protection to angel by providing them with the ability to match or surpass the influences of later investors, or block them altogether.

RESEARCH STRATEGY

To provide legal strategies that angel investors can use to protect against unfair dilution of their angel investment, we began our research by searching through early stage investor education platforms such as Seraf, investment/financial guides such as Investopedia, startup funding resources such as Y Combinator, and startup-oriented magazines such as Inc. While there was an abundance of information on anti-dilution protection, there was nothing on unfair dilutions whereby later investors in a startup can somehow alter the terms of the original deal and wipe out earlier investors.

Next, we searched through business sites such as Toptal and Medium that tap into the mind of business/financial/legal experts to educative content for the benefit of investors and entrepreneurs. We also leveraged expert blogs such as Michael Best as well as financial media resources such as Forbes and CNBC. Again, our efforts were fruitless as we could only manage to find information on how startup angel investors and founders can cushion themselves against future equity dilution.

Our third strategy involved leveraging sites that provide legal services and/or information on startup companies in the hope that they provided content on the legal ways that angel investors can protect themselves from unfair dilutions. Our research produced legal sites such as Springmeyer Law and Startup Legal Stuff that highlighted the various angel investor protections; although mostly regarding equity dilutions. However, Springmeyer Law provides an article that discusses how angel investors can protect themselves using convertible notes. Although convertible notes are not meant to work against later investors, they align the interests of the angel investor with those of future investors, which may offer protection.

Notably, a resource by Seraf outlines several rights enjoyed by angel investors and while they are not necessary/directly legal strategies to protect early pre-seed/seed angel investors from Venture Capitalists who might decide to alter the terms to their favor, we found two that if properly applied might offer some protection to angel investors. In the absence of information that directly addresses the question, we have provided the three clauses as useful information as well as analyses into how they can offer angel investors protection from unfair dilutions.
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