Angel Investor Best Practices

Table of Contents

Introduction

.....................................................................................................................................................3

Author Bios

......................................................................................................................................................6

W. Daniel Mothersill....................................................................................................................................6

Bryan J. Watson............................................................................................................................................7

Frances Fast...................................................................................................................................................7

Dr. Steven A. Gedeon...................................................................................................................................8

Chapter 1 - Formation and Operation of an Angel Group

..............................................................9

Executive Summary......................................................................................................................................9

1.0 Background..............................................................................................................................................9

1.1 A Strong Argument in Favour of Organized Angel Groups............................................................10

1.2 Taking the First Step...........................................................................................................................11

1.3 How to Start..........................................................................................................................................12

Chapter 2 – Sustainability of Angel Groups

......................................................................................17

Executive Summary....................................................................................................................................17

2.0 Introduction..........................................................................................................................................17

2.1 A Sometimes Typical Scenario..........................................................................................................17

2.3 Threats (Internal & External)............................................................................................................21

2.4 Internal..................................................................................................................................................21

2.4 External.................................................................................................................................................26

Chapter 3 - Deal Screening

......................................................................................................................30

Executive Summary....................................................................................................................................30

3.0 Qualifying for Quality..........................................................................................................................30

3.1 Mechanisms for Screening..................................................................................................................31

3.2 Seven Key Questions to Screen Investment Opportunities for Angel Groups............................31

3.3 Companies That Don’t Make the Cut..............................................................................................35

Chapter 4 - Due Diligence

........................................................................................................................36

Executive Summary....................................................................................................................................36

4.0 Due Diligence: An Evolving Discipline.............................................................................................36

4.1 Best Practices Defined.........................................................................................................................37

4.2 Where Due Diligence Fits In the Investment Cycle........................................................................37

4.3 Typical Criteria for Angel Due Diligence.........................................................................................38

4.4 Three Areas of Focus in Due Diligence.............................................................................................39

4.5 The Business Plan: Truth or Consequences......................................................................................43

4.6 A Detailed Due Diligence Checklist...................................................................................................44

Chapter 5 - Valuation

................................................................................................................................48

Executive Summary....................................................................................................................................48

5.0 Valuing Angel Investments in Early-Stage Companies...................................................................48

5.1 Valuation Fundamentals.......................................................................................................................49

5.2 Valuation Trends..................................................................................................................................56

5.3 Pre-Revenue Angel-Round Valuation Methods................................................................................60

5.4 Effect of Angel Groups on Valuation................................................................................................63

Chapter 6 - Term Sheets and Legal Agreements

..............................................................................65

Executive Summary....................................................................................................................................65

6.0 The Term Sheet...................................................................................................................................65

6.1 Term Sheet Specifics...........................................................................................................................66

6.2 Key Deal Terms...................................................................................................................................71

6.3 Papering the Deal: The Investment Package...................................................................................74

Chapter 7 - Negotiation

.............................................................................................................................76

Executive Summary....................................................................................................................................76

7.0 Introduction..........................................................................................................................................76

7.1 Negotiation Fundamentals..................................................................................................................76

7.1 Negotiation Strategy............................................................................................................................80

7.2 Negotiation Tactics.............................................................................................................................81

7.3 Negotiating Specific Deal Terms.......................................................................................................83

7.4 Conclusions...........................................................................................................................................86

Chapter 8 - Deal Syndication

..................................................................................................................87

Executive Summary....................................................................................................................................87

8.0 Introduction..........................................................................................................................................87

8.1 The Draft Syndication Process..........................................................................................................88

8.2 A Sample Four-Pager for Syndicating Deals.....................................................................................90

8.3 Due Diligence Checklist for Deal Syndication.................................................................................94

Chapter 9 - Dilution, Follow-on Rounds, Sidecar Funds, and Exits

............................................95

Executive Summary....................................................................................................................................95

9.0 Introduction..........................................................................................................................................95

9.1 Angel Protection..................................................................................................................................96

9.2 Sidecar Funds – Supercharging an Angel Group Investment...........................................................97

9.3 Follow-on Rounds: An Inevitable Necessity for Some Investments.............................................99

9.4 Exits: An Angel Home Run..............................................................................................................101

Chapter 10 - A Western Perspective

...................................................................................................105

10.0 Alberta...............................................................................................................................................105

10.1 British Columbia...............................................................................................................................108

10.2 Manitoba...........................................................................................................................................111

10.3 Saskatchewan....................................................................................................................................113

Frequently Asked Questions

.................................................................................................................116

Negotiation FAQ.......................................................................................................................................116

Appendices

...................................................................................................................................................119

Fig. 1 – Sample Accredited Investor Declaration.................................................................................119

Fig. 2 – Sample Group Membership Application..................................................................................120

Fig. 3 – Summary of Administrative and Management Functions.....................................................123

Fig. 4 – Sample Term Sheet.....................................................................................................................127

Fig. 5 – Sample Shareholder’s Agreement.............................................................................................133

Fig. 6 – Sample Subscription Agreement...............................................................................................145

Fig. 7 – Sample Voting Trust...................................................................................................................152

Glossary

........................................................................................................................................................156

Works Cited

................................................................................................................................................195

Acknowledgements

...................................................................................................................................196

Age of the Angel: Best Practices for Angel Groups

Introduction

4

Introduction

Creating an investment “bible” for Angels in Ontario is akin to herding lions naked. At best, it’s a high-risk undertaking that leaves one exposed in a variety of vulnerable spots. Angels, active or passive, are by temperament rugged individuals, seasoned entrepreneurs who have forged businesses, commercializedinnovation, and built enduring organizations. They are the last and perhaps best bastions of enlightenedcapitalism in Canada. As such, they are not lightly influenced nor easily persuaded by vague theories or unproven practices.That is why this manual is meant to be strongly prescriptive rather than mildly descriptive. It is based on best practices, and written principally by Angels for Angels. This does not mean that it has everythingright or that one size fits all. Formal group Angeling, after all, is a relatively new and evolving discipline,which has developed rapidly in Ontario over the past several years.But from extensive research on successful Angel groups in North American and beyond, the authors of this manual have aggregated the principal processes that work in the best interests of investors andentrepreneurs. They have focused on the science of the probable rather than on the art of the possible. Indoing so, the authors recognize that there are counterpoints to many of the assertions contained in thisdocument and, given the personality of individual Angels and Angel group members, many of thesediffering views have a measure of validity. However, the authors of this handbook have chosen to sidewith the weight of empirical evidence and present a majority viewpoint.The genesis for this work came from a meeting last year of the presidents of the western Canadian Angelgroups who are affiliates of the National Angel Organization (NAO). They expressed the need for corestandards for Angel investing in this country -- not as a control issue, but rather to ease the investment process when deals are syndicated from one Angel group to another within cities and across provinces.“It’s vital that we have everyone singing off the same investment song sheet,” asserted one Angel group president at the meeting, “there is comfort and confidence in knowing that all Angels are applying thesame metrics to their investment decisions.”For Angel groups in Ontario, syndication of Angel deals is the key to commercialization of great ideas.Venture Capital firms seem to be moving downstream, so more money is required for start-ups to fill thefunding gap between “love money” and later stages of financing. The number of VC players in early-stage investing, while never a major financing source for entrepreneurial companies, is dwindling, whichis perhaps why informal investors, including Angels, today fund more SMEs than VCs do. As Dr. AlanRiding of the University of Ottawa revealed in a 2005 study, VCs invested a little more than $1.6 billionthat year, while business owners alone provided some $11 billion in funding to SMEs.We have entered the Age of the Angel, where high net-worth individuals have effectively become thecommercialization engine for entrepreneurial companies. Availability of Angel investment money is notthe principal problem hindering commercialization of start-ups.