I'm working for a client bringing deal flow and doing due diligence for their angel investments right now. Earlier this week I went to a VC presentation for entrepreneurs with a Q&A session. As early stage investors we often have the opportunity to invest via "convertible debt" as opposed to doing a series A which sets a valuation on the company. As time goes by, if it takes longer and longer to get VC money, your shares get "discounted" off the ultimate VC price, so that you pay, for example, half of what they are paying assuming the share price has about doubled by the time they get their money in.
Now, of course the VCs want the prior investors to have as little power and actual stock as possible, because they're just "getting in the way" once the company is big enough to need and merit VC. And it's cheaper to do a convertible debt investment from a legal perspective, and you don't need accredited investors (I think although I haven't really checked this out). So you hear lots of encouragement to "do this round as convertible debt" from VC's (and consequently entrepreneurs who want VC money).
Anyway, a couple weeks ago at a different event I attended, the VC's who were presenting there (and I'm not naming any names here) laughed at the notion that angels would be allowed to keep their discount. They said they haven't seen anyone keep their discount "in years." The angels are forced to come in at the same price the VC's do, even though they took a much greater risk and probably worked hard to increase the company's valuation between the time they invested and the time the VC's did. For that risk and hard work they get the "reward" of being "permitted" to join the VC on the VC round for the same price. Thanks guys!
I was appalled by this news as this seems like a prime way to screw over your angels and just a license basically for VC's to wield all the power they can.
I did a little research online and found some interesting links (http://www.matr.net/print-
Anyway, back to this week's event. I asked the VC who was presenting there whether it was his experience that VCs did not allow the discounts, and he said it was about 50/50%. He said they would remove discounts "because they can", to which I had to force a bitter smile through gritted teeth to remain polite, but at least he was honest. I mean, honestly. It reminded me of everything horrible you have ever heard about VC's in your life. Like taking candy from a baby!
But then he went on to say that the convertible debt, even if it didn't retain a discount, was a good thing for angel investors because it protected then in the event of a cramdown or a bankruptcy. He was quite satisfied with his response, which is why I referenced conflict of interest in the title of this post. Angel investors don't want to invest in a company they think might go bankrupt, and they should have the right sense of what things are worth in the market to help come up with a good valuation that won't keep the company from getting funded. If they make those mistakes it's on them and it's their own money; most likely if the bet was a bad one they'll end up with nothing, bankruptcy notwithstanding. But if they have a win, they should get their full share. Knowing they're risking it all, why would they care about bankruptcy protection?
In my personal experience, doing a series A with angels wasn't that darn difficult and I think entrepreneurs should give their early supporters their proper upside. If the company is good the VCs will still invest even if there are already shares out there at a lower price. They can always cram it down if they want. Guaranteed returns aren't part of the VC pitch or it wouldn't be called "venture"; it's not the angel's job to help the VC's get those returns.