How to Dance with Angels

Small businesses often prefer to slow dance with angels than boogie with venture capitalists. But knowing when to change partners is also important.

Small-business owners also need to keep an eye peeled for potential legal snares related to angel investors, says OkCupid’s Yagan, who also founded study-aid company SparkNotes. “Don’t go cheap on lawyers. A cheap lawyer costs more than an expensive lawyer,” warns Yagan, who learned that lesson the hard way when he sold his first company.

A clause in the agreement between SparkNotes and its angel backers gave the investors the option to sink more money into the company at any point, thereby increasing their stake in the company. Yagan, a 22-year-old college student at the time, wasn’t sure the company would need to raise more capital beyond the initial investment, so he reached a verbal agreement with his investors that the option to increase their stake would be exercised only if SparkNotes required additional funding.

But the following year, the day before the company was sold to Barnes & Noble, the angels exercised their right to up their stake, increasing their investment by 10 percent. Yagan, his partners, and employees who already held a stake in the company lost 10 percent of what they would have made on the sale.

Speed may be another problem for companies backed by angel investors, mainly because organic growth takes longer than acquired growth. For example, a VC firm often decides to purchase companies, products, brands, or technologies that complement existing portfolio companies, thereby helping the existing business expand.

Adams says he understands the limitations of angel investment, and already has plans to move beyond this type of capital raising. He concedes that having autonomy over his business was good in the beginning, but when it’s time to sell the company, “my investor is going to be zero help. My time to pay the fiddler is coming.” When that happens, Adams says, he will hire an adviser to help with valuation and other tasks to prepare the business for sale.

Once company owners are ready to take the next step and accept VC funding, they will find that choosing the right angel investor at the start was important. Companies should be looking for angel investors who have been through the VC process as a CEO or who have ties to a VC firm, says the NVCA’s Taylor. In that way, the VC firm knows the company has been through “a very good farm system,” he notes.

Attracting VC money, when the time is right, will also depend on how angel financing was structured. Business owners should avoid terms that grant ownership percentages or liquidation preferences to investors that could repel VCs, says Taylor. (A liquidation preference gives investors the right, if the company is sold, to collect a set return on their investment before anyone else receives a payout.) “If the terms are too favorable to the early investor, it will poison the company,” says Taylor. “We see that all the time, especially with inexperienced angels.”

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