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Legal Defence for Business Angels: Protecting your Investments.

Legal defence for angel investors (or business angels) is essential to protect their financial interests. Here is a summary of the key aspects that need to be considered:

1.- Due Diligence:

There is a tendency to relax due diligence before investing in a start-up. This is a mistake. It is true that sometimes it is not possible because the startup is at a very early stage. But even so, it is ALWAYS a good idea to conduct thorough due diligence before investing in a startup. This includes researching the company, its management team and its finances to make informed decisions.

2.- Structure of the Investment:

It is also necessary to determine the structure of the investment, whether it is an equity investment or convertible debt, and to establish the terms of the investment.

The investment structure for business angels can vary depending on the specific circumstances of each investment and the agreements between the investor and the startup. However, here are some examples of common investment structures for business angels:

  1. Equity Investment: In this approach, the business angel invests money in exchange for an equity stake in the startup. The investor receives shares in the company in return for his investment and thus becomes a shareholder of the company.
  2. Convertible Debt: Instead of receiving shares immediately, the business angel provides financing in the form of a convertible loan. The loan is converted into shares of the company at a predetermined future date or when certain conditions are met, such as a subsequent financing round.
  3. Conversion Option Loan: Similar to convertible debt, in this structure the investor grants a loan to the startup with the option to convert that loan into shares of the company in the future, usually at a pre-agreed conversion price.
  4. Investment with Pre-emptive Participation Rights: The business angel can negotiate preferential participation rights that give it priority in the repayment of its investment and, sometimes, a preferential dividend before other shareholders receive payments.
  5. Secure Note Investment (SAFE): This is a popular financing instrument in the startup environment. A SAFE is neither a debt nor a direct equity investment, but grants the investor certain future economic rights in the company in exchange for their investment.

Secure Notes (SAFE) are a financing instrument commonly used in the startup world to facilitate investments by business angels and other investors. These notes were developed by Y Combinator and are used to simplify the investment process in early stage startups. The essential aspects that make up the Secure Notes are described below:

    1. No Interest and No Maturity: SAFEs are non-interest bearing and have no fixed maturity. This means that there is no schedule of interest payments and no date by which the investment must be repaid to the investor.
    2. Conversion into Shares: The main purpose of a SAFE is to allow the investor to convert their investment into shares of the startup in the future, usually when a subsequent funding round occurs or when certain agreed conditions are met. The amount of shares the investor will receive is determined by the conversion terms set out in the SAFE.
    3. Conversion Price: The SAFE must include a conversion price, which is the value at which the shares will be converted when the SAFE is triggered. This conversion price may be based on the price of the subsequent financing round or another agreed mechanism.
    4. Discount: Optionally, a SAFE can include a discount on the conversion price. This means that, at the time of conversion, the investor will be able to acquire shares at a lower price than other investors in the same round.
    5. Cap: Some SAFEs may include an upper limit or “cap” on the conversion price. This ensures that even if the price of the subsequent financing round is high, the investor will receive their shares at a pre-defined maximum price.
    6. Liquidity Events: SAFEs often specify liquidity events, such as an acquisition or an initial public offering (IPO), which may trigger the conversion of the investment into equity.
    7. No Voting Rights or Dividends: Unlike ordinary shares, investors holding SAFEs generally do not have voting rights in company decisions or the right to receive dividends.
    8. Risk Behaviour: SAFEs tend to be more startup-friendly instruments compared to traditional equity investments. They are designed to minimise friction and complexity in the early stages of financing.

It is important to note that while SAFEs are a flexible and commonly used investment vehicle, it is essential that investors fully understand the specific terms of each SAFE and how they will affect their investment. In addition, SAFEs may require adjustments and modifications depending on the circumstances of each startup and negotiation between the parties involved. It is recommended that both investors and startups consult with legal counsel before using a SAFE in an investment transaction.

6. Convertible Bond Investment: In this structure, the investor buys convertible bonds that can be converted into shares of the company in the future, usually in a subsequent financing round or when certain criteria are met.

7. Profit Share Investment: Instead of an equity stake, the investor can agree to receive a percentage of the startup’s future profits until a certain return threshold is reached.

8. Installment investment: Instead of investing a lump sum of money, the business angel can agree to invest in the startup in multiple instalments, with specific conditions and milestones to be met for each disbursement.

It is important to note that the choice of investment structure depends on a number of factors, such as the level of risk, the investor’s preferences, the status of the startup and the objectives of both parties. Each investment may be unique, and it is crucial that detailed agreements are drawn up and that legal and financial advisors are consulted to ensure that the interests of both parties are protected.

3.- Investment Agreements:

It is particularly important, as mentioned above, to draw up clear and detailed investment agreements specifying the investor’s rights and responsibilities, including exit conditions. Exit conditions, preferential liquidation, if any, should be agreed at the time of investment, which is when the investor is “indispensable”. Once the investor becomes dispensable … This will be discussed in more detail in point 6.

4.- Protection of Intellectual Property:

Ensure that the start-up has a sound strategy to protect its intellectual property, such as patents, trademarks and copyrights.

5.- Dispute Resolution:

Establish dispute resolution procedures in case of disagreements between the investor and the start-up.

6.- Exit Plan:

A clear exit plan should be discussed that defines how and when the divestiture will take place, whether through an acquisition, an initial public offering (IPO) or a private sale.

Business angels often consider various exit plan schemes when investing in a startup. The exit plan is essential because it defines how and when the investor will recoup its investment and possibly make a profit. Here are different exit plan outlines that a business angel may consider:

    1. Strategic Sale (Acquisition): In this scheme, the exit plan involves selling the startup to a larger company or competitor in the same industry. This may occur when the startup has developed valuable technology, customers or assets that are attractive to another company.
    2. Initial Public Offering (IPO): In some cases, a startup may choose to go public through an Initial Public Offering (IPO). Investors can sell their shares on the stock market once the company has completed the IPO.
    3. Management Buyout: The startup’s management team can buy the shares from the investors, allowing the business angel to exit the investment. This can be an option if the management team has the resources to do so.
    4. Dividends and Cash Flow: Some startups can generate enough cash flow to pay dividends to investors. In this scheme, the investor recovers its investment through regular dividend payments.
    5. Sale to Another Investor: The business angel can sell its shares in the startup to another interested investor, allowing it to exit the investment. This can occur on the secondary market or through private agreements.
    6. Employee Stock Ownership Plan (ESOP): In some startups, an employee stock ownership plan is implemented. Employees can buy shares from investors as part of an incentive and stock ownership plan.
    7. Partial sale: Instead of selling all the shares, the investor may choose to sell a part of his stake in the startup, allowing him to retain some interest in the future growth of the company.
    8. Licensing or Royalties: In cases where the startup has developed patented technology or intellectual property, the investor may receive income through licensing or royalty agreements as the company generates revenue from the exploitation of those assets.
    9. Liquidation: In extreme situations where the startup is unsuccessful, investors may choose to liquidate the company’s assets and recover a portion of their investment.

The exit plan depends on several factors, including the nature of the startup, its growth and profitability, the investor’s goals and market conditions. It is important that the investor and the startup agree on a clear exit plan when making the investment to avoid conflicts in the future and to ensure a smooth transition when the time comes to exit the investment.

7.- Continuous Legal Advice:

Maintain an ongoing relationship with investment lawyers to address ongoing legal issues and adapt to changing circumstances.

It is essential to have an investment and start-up lawyer to guide angel investors through this process and ensure that their interests are protected at all stages of their investment.

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