Step 5: Evaluate offerings
Published on March 30, 2016
After you identify an offering that you feel optimistic about, review the terms of the deal that really matter—including price, equity percent, valuation, use of proceeds, liquidation preferences, conversion rights, etc.—and be sure they make sense. Then conduct due diligence, perhaps collaborating with or relying on other smart investors or a professional adviser.
For inexperienced angel investors, this is probably the hardest step in the seven-step plan. As you gain experience, you’ll become more competent at evaluating deals—you might even enjoy it, as there is a social component to it. Under Title III of the Jumpstart Our Business Startups Act, crowdfunding portals and platforms must provide communication channels where investors can discuss offerings, and where issuers can answer questions posed by investors.
Evaluating deal terms and conducting due diligence can be complex if you try to do it all by yourself. It’s somewhat simpler if you ask for advice from a lawyer or financial adviser, and/or collaborate with other investors whose opinions you trust. On funding portal discussion forums, you’ll be able to see each participating investor’s profile, and get a feel for which of them are insightful, well informed, and reliable.
We will give you a rough outline of both subjects—deal terms and due diligence—to help you get started. Throughout this article you will find links to resources that provide more comprehensive guidelines on these topics.
A. Deal Terms
When you find a Title III equity offering that seems attractive in terms of its industry, location, product or service, team profiles, business plan, and financial projections—among other offering details and disclosures—your next step is to review the term sheet, which sets forth the rights, obligations, and restrictions that apply to both parties in the deal, the issuer and the investor.
Offering terms vary from one kind of deal to another. Deal terms for a preferred stock offering are different from the terms for a convertible debt offering, for example. Terms for a seed-stage, pre-revenue startup may differ from terms for a growing, established company. There is no single standardized set of terms for all kinds of equity offerings, just as there is no single standard lease for all kinds of commercial real estate.
Securities: straight equity and convertible debt
One of the first terms you will see at the top of page 1 of a term sheet is the type of security being offered. The most common securities offered in equity crowdfunding are stock, LLC membership units, and convertible debt. Stock and LLC shares are straight equity, while convertible debt is a hybrid of equity and debt. Straight equity is more common than convertible debt in angel investments today, although everything is subject to change, especially in this era of fintech and financial innovation.
So we will start by explaining the most important deal terms that you (or your adviser) should know about for straight equity offerings. This includes economic terms, control terms, terms related to liquidity events, and other terms.
Deal Terms for Straight Equity
1. Economic terms
When you invest in straight equity (e.g., preferred stock or LLC shares), the first terms that you will consider are the price per share (either a fixed dollar amount or a formula), minimum investment amount (and additional increments permitted), valuation of the company, and percentage of total equity offered per incremental amount invested.
Many offerings state a certain share price of stock or price per unit of LLC membership. The price alone is not very meaningful unless you also know the percentage of ownership that a share or unit represents. Issuers who are extra-thoughtful will give you both of these figures, but many do not. In any case, they must give you enough information—such as the company’s (proposed) valuation and the total number of existing shares or units—to calculate the percent of ownership that you get when you buy a share, using one or more of these formulas:
100 ÷ Total shares issued = Percent ownership of each share
Investment amount ÷ Company valuation = Percent ownership for the investment amount
To make these formulas meaningful, we need two definitions:
Total shares issued means all shares held by the issuer, granted to employees and directors, sold to investors, and authorized for sale (and held in reserve as employee options) in the current round of financing.
Company valuation is the value on a specific date as proposed by the issuer or, in some cases, as estimated by a third-party valuation analyst hired by the issuer. For private companies, valuation is a highly subjective measure. In a private securities offering, valuation is usually stated in pre-money terms (that is, the value before the current round of financing), although it is sometimes stated in both pre- and post-money terms. (Pre-money valuation plus the amount currently being raised equals post-money valuation.) You should use post-money valuation in the second formula above.
The issuer should reveal what approach, method, or multiple it used to estimate its valuation, and the date on which the valuation was effective—as it can change from month to month. Angel capital valuations typically fall into the $500,000 to $10 million range, although outliers certainly come along.
How do you know if the price is fair? Of course, investors (buyers) want the price to be low, while issuers (sellers) want the price to be high, as in any free-market transaction. Some inexperienced, starry-eyed entrepreneurs assign their startups exaggerated valuations. You should try to judge whether the valuation seems reasonable, as the price is derived from the valuation, but not try to narrow it down too precisely. The key to success in angel investing is not necessarily buying in at bargain prices but buying shares of potentially great companies at fair prices.
Beyond those basic economic terms, you should see other terms such as: fully diluted valuation, use of proceeds, and capital structure. You will find detailed explanations of those terms via the following resources:
- “Deal Terms,” Chapter 11 of Equity Crowdfunding for Investors: A Guide to Risks, Returns, Regulations, Funding Portals, Due Diligence, and Deal Terms, by David M. Freedman and Matthew R. Nutting (Wiley & Sons, 2015) – http://www.ec4i.com
- Venture Deals, Second Edition, by Brad Feld and Jason Mendelson (Wiley & Sons, 2013) – http://www.goodreads.com/book/show/11865558-venture-deals
- Chapters 11 and 12 in Angel Investing, By David S. Rose (Wiley & Sons, 2014) – https://gust.com/guide
As an equity crowdfunding investor, you will probably hold a hyper-minority share of the company in which you invest—that is, a tiny percent of the equity—among dozens, hundreds, or thousands of other investors in your funding class. One disadvantage of hyper-minority ownership is that you, as an individual (as opposed to your investment class as a whole) will have very little control over, or participation in, the governance and day-to-day management of the company.
Gaining even a small amount of control should not be one of your goals when you invest in equity crowdfunding deals. A lack of control should not, however, discourage you from investing in equity crowdfunding deals that let you achieve your social and/or financial goals.
Protective provisions. The terms of the deal should afford your Series CF class, collectively, a measure of control over a narrow set of actions that relate to the long-term value of your equity shares. This narrow area of control will be in the form of protective provisions, also known as veto rights. A typical set of protective provisions in an angel investment states that a supermajority (such as two-thirds) of the Series CF shares can veto any action, whether directly or through a subsequent round of financing or a merger, that:
- Adversely alters the rights or preferences of the Series CF Preferred.
- Increases the authorized number of shares of common or preferred stock.
- Creates any new class or series of shares having rights or preferences senior to Series CF Preferred.
- Results in any merger, corporate reorganization, sale of control, or any transaction in which all of the assets of the company are sold.
- Results in the redemption or repurchase of any shares [other than pursuant to the company’s right of repurchase at a specified cost, if so provided by the terms].
- Changes the authorized number of directors on the board.
- Liquidates or dissolves the company.
Those are some of the more common protective provisions in angel deals, and there are others. Any given angel or VC deal may have several of those protective provisions, but rarely all, in the term sheet. In an equity crowdfunding deal, you might be satisfied with the first one, or maybe the first three, on that list.
3. Terms relating to liquidity events and future financing
The most important factor that drives your return on investment is the consistent growth in profitability of the company in which you invest, or at least the potential for such growth, which in turn makes it a good acquisition target or IPO candidate. Along the way, however, several other factors can strangle your return on investment in large and small ways. Those factors include dilution of share value caused by the issuance of new shares for future financing rounds, the distribution of whatever proceeds might be available in the event of the dissolution of the company, and a sale of the company at a price that is lower than the Series CF valuation. Those are three examples of liquidity events that could result in a disappointing return, if not an actual loss, for investors.
To protect equity crowdfunding investors, who are often in the first round of equity financing outside of friends and family, from the potential constrictions of those adverse or “downside” kinds of liquidity events, the term sheet should include liquidation preferences.
Liquidation preferences. If you invest in 10 equity crowdfunding deals, chances are that you will experience a few liquidations. When a company calls it quits, whether voluntarily or otherwise, it must liquidate its assets in order to pay salaries and wages owed to employees first, repay its creditors and note holders second, and return money—if there is any left—to its investors third. Holders of preferred stock generally have priority over common stockholders.
Liquidation preferences spell out the amount of money, stated as a multiple of their original investment, that preferred shareholders receive in the event of a dissolution or sale. Only after preferred receives its full amount will common (including the founders) get any leftovers. To see how a typical liquidation preference is worded, see Chapter 11, “Deal Terms,” in Equity Crowdfunding for Investors, by Freedman and Nutting (Wiley & Sons, 2015).
In the case where the company is sold at a much higher valuation than in the Series CF deal (we’ll call this an “upside” acquisition)—the liquidation preferences may let preferred shareholders convert their shares to common stock in order to benefit from the capital gain that common shareholders enjoy. (Common stock prices rise and fall freely with market valuations, whereas preferred stock prices are protected—and restrained—from market volatility.)
So liquidation preferences can give early investors, as a reward for taking a big risk, the best of both worlds: the downside protection of preferred combined with the upside benefit of common.
Aside from liquidation preferences, other terms relating to liquidity events that might appear in your deal include: full participation, anti-dilution provisions, right to participate pro rata in future financing rounds, “pay to play,” and drag-along agreements. These are explained in Chapter 11 of Equity Crowdfunding for Investors (see reference above).
4. Other deal terms
The two deal terms in this group are no less important than the preceding ones; they just don’t fit neatly into any of the aforementioned categories.
Conversion rights. In addition to the conversion rights spelled out in the liquidation preferences, preferred shareholders may be granted the right to convert their shares to common stock, either (a) at any time of the investor’s choosing, (b) after a specific date, such as one year after the closing of the Series CF round, or (c) automatically upon the occurrence of a certain event such as an acquisition or IPO. You might wish to exercise this right if you want to vote more actively with the common shareholders, for example, or if you think it would be easier to sell common shares on the secondary markets. Once you convert to common, you can’t revert to preferred.
Whether conversion is at the investor’s discretion or only upon liquidation, this provision sets the conversion ratio—that is, the number of common shares the investor receives for each preferred share on conversion. The typical ratio is 1:1, unless it is adjusted according to an anti-dilution provision or a stock split (which is rare for startups).
Information rights. A typical term sheet in a Regulation D offering states that the company shall provide, at the very least, annual financial statements (reviewed or audited, depending on the amount raised) to each investor within a reasonable time. This provision may be unnecessary in equity crowdfunding deals because Title III requires issuers to do so anyway. Aside from Title III issuers, private companies are not obligated to share financial records with anyone unless compelled to do so by the terms of a securities offering, institutional debt financing arrangement, credit application, or certain legal or forensic proceedings.
Other terms might include: dividends, redemption rights, right of first refusal, co-sale rights, vesting of founder stocker, and restrictive covenants. They are explained in Chapter 11 of Equity Crowdfunding for Investors.
Deal Terms for Convertible Debt
Convertible debt (a hybrid of debt and equity) is a completely different ballgame from straight equity. For a thorough explanation of convertible debt, see “Private Securities,” in the FUNDAMENTALS section of this website.
The most important terms relate to the timing of when (under what circumstances) the debt can convert to equity, and how the conversion price per share will be determined—that is, the amount of equity you will get for every dollar you invested, if and when the conversion happens.
For a detailed explanation of deal terms relating to convertible debt, see Chapter 10 of Equity Crowdfunding for Investors. Here is another good discussion of convertible debt, published by MicroVentures (a Regulation D offering platform focusing on technology startups).
B. Due Diligence
Due diligence is the research that an investor conducts into the issuer, and its associated industry and market, before buying its debt or equity securities. Any investor needs to either conduct due diligence before investing, or ensure that someone—such as an investment adviser or experienced angel investor—has done it reliably.
As a reasonable person, you will not accept on faith every statement, claim, and representation an issuer makes. Not that most issuers will be intentionally deceptive or evasive (some will), but there will occasionally (or often) be inadvertent mistakes, inaccuracies, and miscalculations.
The crowdfunding intermediary is obligated to have a reasonable basis for believing the issuer has met the requirements to offer securities under Title III, codified as Section 4(a)(6) of the Securities Act. But you can’t always rely on the intermediary to conduct thorough due diligence. Some equity crowdfunding sites take additional steps, such as establishing an anti-fraud department or hiring a third party like CrowdCheck to conduct due diligence. This level of due diligence focuses mainly on compliance, rather than the potential return on investment.
Some platforms or issuers hire CrowdCheck to conduct due diligence, advise the company on how to get into compliance where needed, and issue a report, which the company can then post on the equity crowdfunding site (and only on that site) to share with prospective investors.
You can learn how to conduct due diligence yourself—you don’t have to be a securities lawyer or a financial wizard. We will help you get started in this step, and you can dig deeper by reading how-to books for angel investors (see the list at the end of this article).
Participation in the discussion groups and Q&A forums—where investors ask questions directly to issuers and their replies are open to all participants—is available only to registered members of the crowdfunding site. Upon registration, you will be prompted to set up a profile, similar to the way many social networking sites work. Initially you may enter as little or as much personal information as you wish in your profile. You can start with a skeleton profile (name and contact info) and add more personal information once you feel comfortable on the site.
Be aware that other registered investors (and some issuers) will view your profile and possibly conduct a more thorough online search of your background—maybe even call you for a brief chat to judge whether they can rely on your opinions. So eventually you will want to fill in your profile with (only accurate) information that will help other investors, with whom you will collaborate on due diligence, to judge that you are reliable. Be careful in the discussion forums not to unfairly disparage an issuer or other investors—they will be reluctant to share information and opinions with anyone whose profile is incomplete or suspiciously cryptic, or who rants and raves or unfairly criticizes a company or another investor.
This is crowdfunding, after all, and you will have an opportunity to collaborate on due diligence with other investors on the equity crowdfunding site. See our comprehensive discussion of the wisdom (and madness) of crowds. We will emphasize just one point about crowd wisdom here. You will have to use your good sense to ascertain whether comments made by other “investors” are genuine and useful and contribute to illuminating the issues being discussed, rather than intended to hype or sabotage the offering.
Legal, Financial, and Business Due Diligence
Due diligence on an equity crowdfunding issuer can be divided into three buckets: legal, financial, and business due diligence. You do not have to approach due diligence in that order, as long as you (and the people with whom you collaborate) touch all three bases. At the very least you must make sure that someone you trust has looked into the issues in the list that follows, even if you aren’t reading the documents and disclosures yourself.
Legal due diligence includes the following (each item is covered more thoroughly in Chapter 12 of Equity Crowdfunding for Investors: A Guide to Risks, Returns, Regulations, Funding Portals, Due Diligence, and Deal Terms (Wiley & Sons, June 2015).
- Look for any indications of fraudulent activity. Such activity includes false claims, intentional misstatements, material omissions, and guarantees that are too good to be true. (See tips on how to avoid fraud in equity crowdfunding.)
- Make sure the offering complies with SEC regulations.
- Check to see that the company is properly incorporated with bylaws drawn up, or organized as an LLC with operating agreement in good order, or otherwise organized as a legal entity under state law.
- Make sure the company maintains minutes of meetings of the board of directors or managing members.
- Check to see if the company has all necessary state and local registration and relevant permits and licenses to conduct its business.
- The company should own its website domain and rights to the website content.
- The company’s bank account should be wholly separate from its owners’ personal accounts.
- Investigate whether the company is involved in litigation, and if so, what is its potential exposure to liability.
- Look into any history of bankruptcy, unfulfilled tax obligations, or liens against property or other assets.
- If the company claims that it owns intellectual property—patents, trademarks, and/or copyrights—check to see if it has current registrations or appropriate protection.
Financial due diligence includes the following:
- Review the company’s financial statements, which owners and managers use to assess their company’s fiscal health, determine its ability to generate cash and cover short-term operating expenses and longer-term debt, and plan for the future. Pay particular attention to three metrics: net profit (or loss), total revenue, and profit margin. (See the FUNDAMENTALS article on Financial Statements and Key Ratios.)
- Other financial considerations include: burn rate, revenue projections, previous capital raises, and others.
- More details on how to research these items in Chapter 12 of Equity Crowdfunding for Investors.
Business due diligence includes the following:
- Based on your own life, education, and business experience, consider whether this a product or service that you would use, and how much you would pay for it.
- If the company sells its product or services to consumers in your area, test it out. Buy the product, eat at the franchised restaurant, use the software. Is it just good, or is it exciting? Does it solve a common problem? Is it better than the competition? Is there or will there be a demand for it? Will the market ever be huge; if not, will margins (price minus cost to produce) be high enough for the company to thrive in a niche market? Will the novelty of the product require consumer education? If it’s a local company, be sure to swing by its location. Is the business really there, and are people really working there (as opposed to occupying space for the sake of appearances)?
- If the product is innovative (and if it is not patentable), how soon will competitors crop up like weeds and fight for market share? Will there be large competitors with virtually unlimited capital that can produce and market the product faster and cheaper? What are the barriers to entry? What is the company’s plan for preempting the competition or differentiating to protect market share?
- Read profiles of the founders and management team (including directors, c-level officers, shareholders who own 20 percent or more of the company, and key advisers) – their experience, reputation, character, and how they get along with each other. For a more thorough discussion on this topic, see our FUNDAMENTALS article here.
- Review the following, usually found in the issuer’s business plan: customer base (size and potential for growth), suppliers (reliable?), marketing strategy, competitive advantages, exit strategy (acquisition, IPO, etc.). See our FUNDAMENTALS article on reading business plans.
ABCs of Private Securities (preferred stock, LLC shares, convertible debt)
“Due Diligence Guide,” a unit of the Venture Capital Education Center, on the MicroVentures website. MicroVentures is a Regulation D offering platform.
Venture Capital Investing: The Complete Handbook for Investing in Private Businesses for Outstanding Profits, by David Gladstone and Laura Gladstone, FT Press (Financial Times), 2003
Venture Capital Due Diligence: A Guide to Making Smart Investment Choices and Increasing Your Portfolio Returns 1st Edition, by Justin J. Camp (Wiley, 2002)