The question is which one to use for any given deal? Are there rules to follow? Market norms? The short answer is only rules of thumb, but there are industry norms. These norms are important for one critical reason. If a company deviates from them, then later investors will either balk or force the company to correct its mistakes. Thus, we ALWAYS counsel investors and entrepreneurs alike not to be clever in their term sheets and closing vehicle terms.
There are several questions to ask yourself when selecting a deal vehicle:
- Is the company asking for seed, growth, or scaling capital?
- Do you want to take K-1 losses with the offsetting risk of unfunded gains in the next first two – three years of the investment?
- Do you think the company’s exit strategy is viable? Does the management team really want to exit?
- Do you want to take your return as a lump in the future or over a shorter horizon.
- Do you think the company is ready for a professional round or will raise a new, preferred round of capital in the near future?
- What is the use of funds (reach a key valuation changing milestone or growth capital)? How long does the company intend to run on this capital?
- If you believe the company is in need of a true bridge to a valuation changing milestone and will raise a new preferred round of capital within 12 months, then use a Convertible Note or a SAFE Note. Neither of these will generate a K-1 if you are investing in an LLC. They also do not have voting rights or Boar of Directors rights. They are easy and cheap to execute and very common vehicles in the market. Just beware that entrepreneurs love these vehicles because they don’t have to set a valuation for the company and are often used as a crutch when a more meaningful model is more appropriate. SAFE and Convertible Notes are generally used for very early seed-stage investments.
- If you believe the company does not have a serious exit potential or strategy or you would like your return over a shorter horizon, then use a revenue sharing deal vehicle. They typically have a faster ROI and can return a very healthy return if the company performs as planned. This is a vehicle that you can use for growth oriented “lifestyle” companies. This vehicle will create a 1099 each year.
- If you believe the company will try to run for more than a year on the capital raised, is raising a round of at least $1M, and is preparing for a significant professional round within 12 – 18 months, then the Series Seed should be used. It does create a class of shares, but is reasonably cheap and easy to execute. It provides voting rights and certain investor protections. It may include a Board of Directors seat. If you are investing in an LLC, it will generate a K-1 each year. The Series Seed template is generally considered a seed-stage deal vehicle, but for a company that plans to raise significant capital in preparation for a professional round of financing.
- If the company is asking for more than $1M, is seeking multiple angel groups, angel funds, and venture capital funds, then they are seeking a professional round and should use the industry standard Series A Convertible Preferred vehicle. This is very expensive and time consuming to execute, but it smooths the company’s path to further funding rounds from professional investors and institutions. The Series A is not a seed-stage vehicle. It is appropriate for growth and scaling companies.
For more information:
- Y Combinator – A Guide to Seed Funding
- Venture Hacks – How to Close an Angel Round
- Startups.co – How To Get Angel Investor Agreements Using Win-Win Deal Structures
- Entrepreneur – Closing a Startup Financing Deal
Disclaimer: we are not lawyers or registered brokers. So, this information is not to be misconstrued as either legal or investment advice.
This is published under the Appalachian Regional Commission POWER Grant, PW-1835-M
Copyright Appalachian Investors Alliance, Inc. 2018
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