3 questions to smart minds

Dealing with Business Angels

For this 3 questions to C. von Einem

White & Case
Photo: C. von Einem | White & Case
16. Janu­ary 2013

While the finan­cing of start­ups by busi­ness angels has a much longer tradi­tion in the USA and has also deve­lo­ped accor­din­gly due to exit condi­ti­ons, it is still not the norm in this coun­try. How can seed funding for start­ups be made easier? What are the Dos & Don’ts when deal­ing with busi­ness angels?

For this 3 ques­ti­ons to Part­ner at White & Case in Munich

1. Is it true that busi­ness angels are incre­asingly provi­ding funding to young compa­nies (instead of VC firms)?

Busi­ness angels have become an inte­gral part of the early-stage finan­cing of German tech­no­logy compa­nies. Although insti­tu­ti­ons such as the High-Tech Grün­der­fonds (HTGF) and Bayern­Ka­pi­tal are very powerful state seed finan­cing insti­tu­ti­ons, they too can only launch young compa­nies finan­ci­ally toge­ther with busi­ness angels who are also invol­ved in the opera­ti­ons of the young compa­nies. This is espe­ci­ally true because VC funds typi­cally do not subscribe to invest­ment tickets of EUR 200,000 to EUR 1 million, but rather, due to their fund sizes, only aim for invest­ments of EUR 1 to 2 million and a total finan­cing volume per target of appro­xi­m­ately EUR 5 million. Smal­ler ticket sizes make no busi­ness sense for them with fund sizes of EUR 50 million to EUR 100 million in view of the admi­nis­tra­tive effort invol­ved. Accor­din­gly, it is most welcome that busi­ness angels are beco­ming incre­asingly visi­ble with their finan­cing contri­bu­tion and will hopefully soon attain a simi­lar importance as in Sili­con Valley.

For this very posi­tive deve­lo­p­ment, it was and is important that enough entre­pre­neurs mostly actually earned money with their early entre­pre­neu­rial acti­vi­ties, because only such people are really willing to put his hard-earned money back into entre­pre­neu­rial risk. — In addi­tion to one/two dozen well-known and large German busi­ness angels, who also make invest­ments of ggfs. 100,000 per target, there is an incre­asing number of busi­ness angels in Germany who are willing and able to invest between EUR 20,000 and EUR 200,000 per invest­ment in young compa­nies, with an average of 10 invest­ments for reasons of risk diver­si­fi­ca­tion. These Angels are incre­asingly orga­ni­zing them­sel­ves into infor­mal circles to get suffi­ci­ent deal flow this way. Thus, it is mostly only possi­ble to get in touch with busi­ness angels through corre­spon­ding busi­ness angel circles or networks, as there are no offi­cial lists of busi­ness angels willing to invest. In this respect, busi­ness angels — unlike VC compa­nies — are usually very diffi­cult for foun­ders to find and approach.

2. What should foun­ders know when deal­ing with busi­ness angels?

Foun­ders should treat busi­ness angels no differ­ently than venture capi­tal inves­tors. Both cate­go­ries of inves­tors prima­rily provide foun­ders with their finan­cial resour­ces. Both cate­go­ries of inves­tors also adver­tise that they can and want to help foun­ders not only with “dumb” money, but also with active help in deve­lo­ping their compa­nies. Howe­ver, you can often expect a little more “hands-on” from busi­ness angels. Howe­ver, as a foun­der, you should be careful not to give the busi­ness angel shares prima­rily for his active help, but for his capi­tal investment.

When desig­ning the legal frame­work for a parti­ci­pa­tion of busi­ness angels in young tech­no­logy compa­nies, it is important to ensure that the frame­work condi­ti­ons are as simi­lar as possi­ble to those typi­cally used by venture capi­tal inves­tors, e.g. exclu­si­vely parti­ci­pa­ti­ons in corpo­ra­ti­ons, prefer­red shares with liqui­da­tion prefe­rence, protec­tion against dilu­tion, certain veto rights and a vest­ing of foun­ders’ shares. Howe­ver, inso­far as shares are also agreed for the work perfor­mance of the busi­ness angel, it must be precis­ely defi­ned how many days per week per percen­tage point of parti­ci­pa­tion are actually to be worked on the part of the busi­ness angel and what happens if the busi­ness angel does not fulfill this obli­ga­tion in the end.

3. What should busi­ness angels look for in their investments?

Busi­ness angels should always struc­ture their invest­ments in young tech­no­logy compa­nies in such a way that further finan­cing rounds, which are inevi­ta­ble in 99% of all cases, are not hinde­red by this or the condi­ti­ons of diffe­rent finan­cing rounds are largely simi­lar in terms of tech­no­logy and legal struc­ture and only vary in terms of valua­tion — i.e. the amount to be paid per share to the young company. This can ensure a rudi­men­tary alignment of inves­tors’ inte­rests. If angels follow stan­dard venture capi­tal contrac­tual provi­si­ons, they can also more easily ensure that venture capi­tal inves­tors can be inte­gra­ted into an invest­ment port­fo­lio in later finan­cing rounds without signi­fi­cantly chan­ging the over­all structure.

Essen­tial regu­la­ti­ons for secu­ring their invest­ments for busi­ness angels are regu­la­ti­ons (i) via a pre-satis­fac­tion = repa­tria­tion of angel invest­ments in the event of an exit (liqui­da­tion prefe­rence), (ii) the protec­tion of the Angel, in case a future finan­cing round takes place at a lower valua­tion (down round), that he can demand an adjus­t­ment of the share­hol­ding ratios for his earlier invest­ment, so that he is not unduly punis­hed for his — unfort­u­na­tely — exces­sive opti­mism, (iii) arran­ge­ments between the foun­ders and between foun­ders and inves­tors that foun­ders lose part of their shares if they are not available for the imple­men­ta­tion of the project for the initi­ally agreed period of at least three to four years (so-called foun­ders’ vest­ing); and (iv) appro­priate corpo­rate gover­nance, i.e. an advi­sory board struc­ture in which inves­tors do not auto­ma­ti­cally have a majo­rity, but in which key decis­i­ons cannot be made against the will of the inves­tors either and, moreo­ver, both the foun­ders and the inves­tors as well as indus­try-expe­ri­en­ced experts are made available to the company as coaches.

Finally, it should be noted that it makes little sense not to take exces­si­vely high parti­ci­pa­tion percen­ta­ges from the foun­ders in seed finan­cing despite the high risk of young compa­nies, as it can then often happen that further finan­cing rounds dilute the foun­ders to margi­nal parti­ci­pa­tion percen­ta­ges of 2 to 5%, at which the foun­ders may lose inte­rest in the project because they feel they cannot profit from any value they gene­rate anyway. In this respect, it is advi­sa­ble for both angels and foun­ders to draw on more or less stan­dar­di­zed contracts, which have proven them­sel­ves hundreds of times over and can be imple­men­ted effort­lessly, when draf­ting their contracts with the help of lawy­ers who have alre­ady prac­ti­ced this trade for many years or decades.

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