3 key legal tips for securing angel financing

(Editor’s note: Scott Edward Walker is the founder and CEO of Walker Corporate Law Group, PLLC, a boutique corporate law firm specializing in the representation of entrepreneurs. He submitted this story to VentureBeat.)

Since I moved to Los Angeles from New York City in 2005, I have been involved in a number of angel financings.  The deals, I’ve noticed, run the gamut – from an angel handing a check to an entrepreneur and instructing him to “send the paperwork when it’s ready” to an angel retaining a large, aggressive law firm and insisting on shares of preferred stock, with all the “bells and whistles.”

It can be a confusing process for the start-up owner. If you’re in the midst of seeking funding from Angels – or are about to start, here are three key legal tips to help you through the process:

Push for the issuance of convertible notes

As noted above, angels will sometimes request shares of preferred stock for their investment. If the start-up is raising less than $750K or so, it’s generally not in the company’s interest to issue them, though.  Preferred stock financings are complicated, time-consuming and expensive.  Moreover, the company would need to be valued, which is obviously difficult at such an early stage and could be extremely dilutive to the founders.

You’re better served by issuing convertible notes to angel investors, not equity. In other words, the angels loan money to the company, which automatically converts into equity in the first professional (the “Series A”) round of financing. This approach keeps the financing relatively simple and inexpensive and will defer the company’s valuation until they’re a bit more established.

If the angel insists on equity, issue shares of common stock — which places them in the same boat as you (though it still requires a valuation and could cause problems with respect to stock option grants).

Do due diligence on the Angel(s)

In the course of my 15+ years of practicing corporate law, the most common mistake I have seen entrepreneurs make in any dealmaking context is the failure to investigate the guys (or gals) on the other side of the table.  Entrepreneurs tend to forget that they will, in effect, be married to these people for a number of years.

At a minimum, get references and speak with other entrepreneurs and founders who have done deals with this person, so you can make an informed judgment as to whether he or she is an appropriate individual for you to partner with.  Issues to consider include:  What is the angel’s motivation to invest?  Is he a good guy or a jerk?  Can he be counted-on and trusted?  Will he add significant value through his contacts, technical expertise or in other ways?

Inadequate diligence happens to everyone – even smart entrepreneurs. Brandon Watson experienced this after getting investing in his company IMSafer. He raised $1 Million in eight days, but was subsequently “bullied” by his Board. The diligence factor, he says, “was that I knew them, but had never taken money from them.”

Never subject yourself to personal liability.

It is self-evident that founders should not be personally liable to angel investors if their company fails (other than in connection with fraud).  Indeed, that’s one of the principal reasons for forming a corporation (or limited liability company): To protect the entrepreneur against personal liability (see tip #1 of “Launching a Venture: Ten Tips for Entrepreneurs).”  Unfortunately, there are angels and very aggressive (or inexperienced) attorneys who will request that the founders personally make certain representations and warranties.

I was involved in two separate angel financings in the past 18 months in which the angel’s legal counsel insisted on just that. In one deal, the angel requested a personal guarantee from the founder.

My tip here for entrepreneurs is simple:  Never, never agree to potential personal liability.  Every sophisticated player understands that angel investing is a “high risk, high reward” proposition, and there is no reason whatsoever that an entrepreneur should be sticking his neck out and subjecting himself to any personal liability if the deal sours.  If an angel is pushing this issue, it’s time to find a new one.

Photo by caruba via Flickr.