Red Flags with Angel Investors

In 2021, I saw countless startups raise their first round of capital. It was a year where many of these companies, a lot of them led by first-time founders, were able to secure funding from institutional investors with very little to show, often with no more than an idea. Some of these startups raised millions of dollars. It was a bull market, to say the least.

A Different Picture in Tougher Times

However, we're no longer in that market. In this down market, I'm noticing a significant shift. More and more founders are coming to the realization that they need to offer more to convince institutional investors to invest. Now they are focusing more of their efforts on trying to bring Angels onboard to help get them to the next stage. As a result, I'm getting many more questions from founders related to angel investors and deal negotiations.

Red Flags

This surge in interest has led to a list of red flags and mistakes that I frequently observe people making when dealing with Angels. It's worth noting that many of these issues crop up because founders often feel a sense of desperation. They need the money, and can sometimes cloud their judgment. Some of the red flags that I see as a sign that a founder should perhaps walk away from a particular investor include:

Over-Negotiation and Added Complexity

Over-negotiation about terms and adding unnecessary complexity to the investment is quite common. I've frequently seen angels wanting to modify SAFE agreements to add interest payments and additional elements making sure they get paid back at a certain time.

This behavior often indicates to me that these are investors who don’t understand early-stage investing and what they’re getting into. It’s akin to taking a small $10,000 investment from a random dentist who expects regular updates, questions your decisions, and adds more stress without providing much strategic value.

Unreasonable Term Modifications

Another issue I've come across is Angels asking for anti-dilution provisions. This type of Angel investor, who might have been influenced by watching something like "The Social Network," where a founder was dramatically diluted out of a company, can be more trouble than they’re worth. They ask for broad blanket anti-dilution in perpetuity for all rounds, meaning as the company gets bigger and bigger that the angel could maintain their percentage ownership throughout the life of the company. That’s a hard no for me- this is likely someone who doesn’t understand early-stage startups and the type of angel investor who will be way more of a headache than you want.

(Side note: standard NVCA financing docs include language for anti-dilution in the case of down rounds..but that’s different)

Seeking Sweeteners

When Angels ask for sweeteners, like warrants or other benefits that increase the value for them, make sure they are significantly strategic investors who will provide additional value and commitment beyond their check. If it’s someone who will spend meaningful time with you on a regular basis, these are the situations where granting warrants might be warranted 😜.

Unnecessary Corporate Governance

Angels asking for board seats early on is a red flag. Corporate governance is hard to unravel once you start going down a certain path. There's no need for an angel to have a board seat so early in a company's lifecycle.

Suspicious Funding Sources

Lastly, any sign of shadiness around where the capital is coming from could cause more headaches than it's worth. If the money seems to come from ill-gotten gains or volatile sources like crypto, it's wise to think twice before accepting the money. Obviously easier said than done if you need the money and the money is there, but I've seen situations where taking money from the wrong people can make your life miserable and tie you up in situations that you do not want to be a part of.

Additional Tips: Complexity in the Cap Table and Valuation Optimization

Remember that adding different Angels into different SAFE agreements can add unnecessary complexity in the cap table. Most of the time founders do this to minimally reduce dilution / maximize valuation.

Especially when talking about the first money into the company, I don’t like seeing founders trying to overly maximize their valuation with Angels. Founders should respect their first Angels, especially friends and family. These investors are taking a significant risk with their own money, different from VCs who are risking other people's money.

The complexity that tons of SAFEs create after conversion is real too and not fun! If you want to learn more about this topic, hit up Michael Gorback on Twitter (@mgorb79). He’s the startup lawyer I’ve collaborated most around these things. We’ll try to write something on the topic soon…

The Positives of Engaging with Angels

Even with all these red flags to watch out for… I want to be clear in saying great Angels can be amazing value adds to a company. They can enhance your network, provide informal advice, and share strategic expertise. Once you get the right Angels on your cap table, it presents a significant opportunity. These investors have taken a leap to support your dreams- that's why they're called Angels.

Takeaways

Recognize and avoid red flags: Be vigilant about spotting red flags when engaging with Angels, such as over-negotiation, requesting board seats, and displaying a lack of understanding about early-stage investing. Walk away from deals with investors that show these warning signs to save yourself potential future headaches.Protect your cap table: Be mindful of unnecessary complexity in your cap table by limiting the number of SAFEs with different Angels. This will help you maintain a cleaner and more manageable cap table as your company grows.Treat Angels fairly: Don't try to overly maximize your valuation with the first Angels who come onboard, especially friends and family. Respect their investment and acknowledge the risk they're taking by supporting your dream with their own money.Leverage your Angels' strengths: When you've got great Angels on your cap table, capitalize on their expertise, network, and strategic vision. They have much to offer beyond just their initial investment. Don't be afraid to tap into their resources to help grow your company.Build relationships with value-add Angels: Keep in mind the long-term benefits of collaborating with high-quality Angels who share your vision and can provide guidance and support throughout your startup journey. Develop strong relationships with these supportive investors, as they can play a vital role throughout your company’s lifecycle.

Be chased,
Jason