I have a small angel fund with a few friends. We are not able to invest more in later rounds in all our best deals, as later stage funds want to squeeze us out. Is there anything we can do to protect ourselves?
All successful gambling strategies dictate that you maximize winners and minimize losers. If you cannot get serious cash into the winners once the deal is de-risked, you are making all your investments of equal value, which requires you take an outrageous (and market unacceptable) amount for each of your investments. Being excluded from the best deals means you are running and insurance pool with only the sick patients, as the healthy ones leave you behind.
Early stage investors have one of the hardest jobs in the entrepreneurial economy. They must source and mentor the most promising deals, taking the highest level of risk of any investor, yet are poorly treated by both those same entrepreneurs and later stage investors. Without early stage investors achieving real returns for their risk, the whole startup ecosystem collapses, as no one will fund companies at their riskiest points.
Later stage funds frequently squeeze early stage investors. They may, with the connivance of founders, create large option pools and “green up” the founders, thus diluting the early stage investor. They may refuse to permit further investment beyond the legally required pro rata amount. They may require the impairment of important rights in early investment documents, like convertible notes or SAFEs, or impose needless recapitalizations to change the economics of the early rounds. I am hesitant to list all the ways I have seen later stage investors hurt early investors, and I do not wish to create a play book here for the unscrupulous.
Such mistreatment is not reserved for lower tier angels. Even some of the top angel investors find themselves at the wrong end of games played by later stage funds. Of course, such games could not occur without the willing assistance of entrepreneurs, who are all too eager to “trade up” for the bigger fund name and personally improve their economic situation once they are the hot commodity. When companies become successful, they forget who took the risk when they were nobody.
What should you do as an angel? I have three major suggestions. First, I would have a clause that gives you a super pro rata right to invest in the next professional financing. Maybe up to $1 million or 30% of the next round, or whatever seems appropriate given your risk profile and original investment amount. The company may ask you to cut back, but you will hold the power to block a transaction should you feel you are being treated unfairly. This strategy permits you to get real cash into the winners. If you do not have the funds to invest yourself, you can create a special purpose vehicle and raise funds from your network for a hot deal they otherwise could not get into.
Second, you can have a side agreement with the founders that they have to pay to you any “overage” from deal exits if the economics between you and the founders shifts in the future through manipulation. Many early Latin American venture shareholder agreements, in fact, had such a clause to prevent founders from gaming earnouts and sign on bonuses with acquirers to shift some of the deal consideration away from investors. Such clauses have the effect of stopping skullduggery before it occurs.
Third, make sure your investment documents protect you on common issues, like what happens upon an early exit, information rights and protective provisions, blocking rights for certain transactions, “most favored nation” clauses so you are treated no worse than any other investor, and clarity on what happens when rounds are not closed within a certain amount of time.
There are other suggestions I can give, but these cover 90% of what will likely help you. These rights are for real angels who invest serious amounts and work hard to add value. If you are investing less than $250,000 to $500,000, or are mostly disengaged, please do not ask for these rights. In that situation, such rights will do more harm to the entrepreneurial ecosystem than good.
For entrepreneurs, never ask a later stage investor to impair your early investors if they have behaved ethically and offered you normal terms. Some early stage investors are cancers and we will gladly help you figure out how to neutralize their damage. But whenever a CEO asks us as a later investor to undo a fair deal with an earlier investor, our interest ends. We do not want to invest in entrepreneurs who mistreat those who took the early risk. It shows a lack of gratitude, hurts the entrepreneurial economy, and shows us that this entrepreneur is someday going to ask an even later investor to destroy our terms.