Startup Investors Guide: Angel Investing Etiquette
Investing in early-stage startups has grown from being the small province of a very few to a far larger category of investment. The U.S. angel investment market grew to $24.6 billion in 2015, independent of traditional venture capital and institutional investors. More people join the ranks of angel investors every day. While the proposition may seem straightforward—invest in young companies, help them grow, and succeed if and when there's a good exit—there exist all kinds of investor norms, little and big, that have developed within the industry.
For startup investors, it's best to understand what some of these standards are before sorting through company pitches and querying founders with due diligence questions. Most practices within the angel investing sphere have emerged out of pragmatism.
Some of these standard practices can confuse even the most thoughtful of investors. Take this piece as a primer on how to build a reputation for fairness and a deft understanding of ground rules as they now exist in the angel investing space.
The tips we've detailed below include:
- Convertible notes aren’t normal debt instruments
- Don't dither when it comes to making an investment decision
- Investors should only ask for information that can push their process forward
- Be judicious when pinging founders
- Don't offer help unless it's actually help
Convertible notes come with unwritten expectations
When an injured player falls to the grass in soccer, it’s expected that the team with possession, especially if it’s the opposing team, will kick the ball out of bounds and give the hurt player a chance to be treated. It's just as expected that the team with the injured player will quickly return the ball after play restarts to the team that kicked it out of bounds.
Only frequent spectators of soccer and people who play it will know this, however. People new to the game will have to learn about this expectation through somebody telling them about it, or through their own experiences. It’s not written in an official rulebook. The same goes for some of the standard expectations and practices around convertible notes, which are a common financing instrument for early startups.
Investors buy the notes, which convert into equity during a subsequent fundraising round, frequently with a discount and/or cap applied relative to what other investors pay in that future round. Misunderstandings around the notes can arise because they are legally debt instruments, but the angel/venture capital industry has established etiquette around how to handle them—and it's different than how a corporate note or any other conventional bond might behave.
As with other debt instruments, convertible notes come with a maturity date that indicates when the note and its accrued interest should be repaid to note holders. But in practice, startup investors typically amend the note, pushing off the maturity date for at least another year. Calling for the note to be repaid benefits nobody, as it will likely bankrupt the startup and leave investors with close to nothing. It's in the investors' interest to give the company as much time as possible to find paths to sustainability, a larger venture round, and/or an exit.
Startup investors who buy convertible notes should understand that they're not buying a certificate of deposit, they're buying in on the chance that the company will find a way to grow and scale rapidly, with the chance to bring investors outsized returns of 10x or possibly more.
With that in mind, investors should also avoid spending time negotiating the interest rate on the note, as it will be immaterial to an investor's portfolio and its returns. Standard interest rates on many notes for Bay Area companies go as low as 2%, and they typically won't top 8%.
Pushing for note repayment instead of extension of maturity date and pushing for different interest rate terms sends a bad signal to founders and fellow experienced startup investors alike, and misses the point on the upside of convertible notes for startup investing.
Don't dither when it comes to making an investment decision
Decisions are based on information. Gaining complete information is almost never possible with any investment, and particularly so with startup investing. Startup investors need to act on the information available to them, render a decision, and let founders know if it's affirmative or negative in a timely manner. Ben Horowitz of Andreessen Horowitz says angels should make a decision after one or two meetings.
The best investors don't wait for a herd to form, desperate for social proof. They're confident in their own decisions and process—and will earn entrepreneurs’ respect because of it.
FundersClub’s Jerrod Engelberg has previously written about the value of founder time and what this means for founders and for startup investors in this illuminating blog post.
"Entrepreneurs need to have countless meetings to raise capital, investors owe it to them to respect their time," says Richard J. Foster, managing director at AngelFire Ventures, on Long Island.
By dragging out a decision and waffling, investors waste not only entrepreneurs' time, but they also waste their own. Judging investments based on their merits—rather than the barometer of others' reactions—is a sign of a superior investor.
"The only thing worse than a 'no' for founders," says Tech Coast Angels’ Chairman, John Harbison, "is the purgatory of a 'maybe'."
Only ask for information that can push an investment process forward
Just because an entrepreneur will scramble to find diligence data for an investor doesn't mean the investor should ask for it. Investors should certainly request details that will be key to a decision, but avoid asking for piles of other data just because they can.
Asking for information when they're not part of an investor's actionable decision-making framework creates superfluous work for not only the entrepreneur, but also the investor, who has to ask for it in the first place, and then wade through the report when it's finally produced.
A best practice here is to play forward the investment process and determine ahead of time what specific information one needs to make a yes/no decision. Then focus on seeking that information specifically, vs. making generic, over-reaching requests.
Be judicious when pinging founders and focus on being value-added
Founders face the same kind of time constraints as everybody else—except they're expected to create a big company, which, of course, is why angels and VCs back them. It's best for everybody, founders and investors alike, if the entrepreneurs are able to spend as much time as possible taking care of their most imperative job.
Tracking down ad hoc reports and answering investor emails packed with queries subtracts from the amount of time a founder can work on product, on growth and on solving problems critical to the business. Investors do have a right to know what's going on with their portfolio companies, but that right has to be weighed with maximizing a portfolio's value and respecting an entrepreneur's bandwidth.
With this in mind, Ben Horowitz, in the same piece referenced earlier, warns entrepreneurs to be leery of angel investors who act like VCs. He notes that a16z behaves differently, depending on whether it has invested a smaller amount, like an angel, or if the firm has led an A or later round, the latter likely giving the firm a board seat and more room to ask things of the entrepreneur.
Ganesh Ramakrishnan, an angel and founder at Finvoice, a marketplace for short-term loans based on businesses' outstanding invoices, says that instead of demanding updates, angels who want to be involved should ask for ways in which they can help. "An update on the startup normally follows that conversation anyway," says Ramakrishnan. "Founders can even forget to reach out for help sometimes, so proactively asking how you can help can save founders a lot of grief."
Don't offer help unless it's actually help
Founders will often ping investors for help with certain matters, often for connections, including those to potential hires, clients/partners, or other investors. These calls for assistance are serious solicitations—founders normally don't reach out on a whim—so they should be treated as such.
Investors should offer any help and make any connection that is germane and could yield an advantage for the startup, but they should eschew from offering up contacts or help that's periphery.
Bottom line: investors don't get points for aimless participation. Angels should only pipe up with true opportunities to help founders' businesses.
The growing ranks of angel investors deserve a lot of credit for the surge of startup activity in the United States and across the world during the last decade. They provide that vital early financing that makes the idea of a startup possible for so many founders. These investors together comprise the world’s incubator.
As the space has grown, so have its nuances and complexities. The expectations for investors’ etiquette has risen with their numbers.
Most of the advice here comes back to one maxim: investors shouldn’t waste founders’ time, or their own. That’s the best thing not only for an investor’s portfolio, but also for their reputation, which, in the end, is as important as anything when landing the best startup investments possible.