Lesson 7: Common Investment Vehicles and Term Sheets —Decoding the Deal

Jan 12

Congratulations on making it to this crucial lesson! We've discussed the mindset, strategy, and diligence required for angel investing. Now, it's time to dive into the legal and financial instruments that structure these deals. This is where your money is committed, so a thorough understanding of the investment vehicles and their associated legal terms is paramount to protecting your investment.

This lesson will provide a deep dive into the three most common early-stage investment vehicles: SAFEs, convertible notes, and priced equity rounds. We will also explore the key terms you'll encounter on a term sheet, with a special focus on the critical concept of pro-rata rights.

The Investment Vehicles Explained

1. SAFE (Simple Agreement for Future Equity)

The SAFE is a relatively new and popular instrument, especially in the pre-seed and seed stages. Created by Y Combinator, it is a simple agreement that provides an investor with the right to receive equity in a future priced round. It is not debt, so it does not have an interest rate or a maturity date.

How it Works: A SAFE is an agreement to convert your investment into equity at a later date, typically when the company raises a "qualified financing" or "priced round" (e.g., a Series A). The conversion price is determined at that time, based on the terms outlined in the SAFE.
Key Terms:

Valuation Cap: A maximum valuation at which your investment will convert into equity. This is the most common term. The purpose of a cap is to protect early investors from a high valuation in a later round, ensuring they get a better price per share than new investors.
Discount Rate: A percentage discount off the share price of the next financing round. This rewards early investors for their initial risk. For example, a 20% discount would mean you get shares at 80% of the new investors' price.
Pro-Rata Rights: This is a crucial right, which we'll cover in more detail below. It gives you the option to invest in future priced rounds to maintain your ownership percentage.

Pros for Investors:

Simplicity: SAFEs are a short, standardized document, which makes them faster and cheaper to execute than a convertible note or priced round.
No Interest or Maturity Date: You don't have to worry about interest payments or a maturity date, which can force an unfavorable conversion if the company hasn't raised a new round in time.

Cons for Investors:

Uncertainty: Because a SAFE is not debt, it has no legal mechanism to demand repayment if the company fails. Your investment is entirely dependent on a future equity financing event.

2. Convertible Note

A convertible note is a form of short-term debt that converts into equity at a later funding round. It is a more traditional vehicle than a SAFE and has characteristics of both a loan and an investment.

How it Works: The company receives a loan from you, and in return, you get the right to convert that loan into equity at a future funding round. If the company fails, your note is debt, giving you a liquidation preference over equity holders (though this is often a theoretical benefit in a startup failure).
Key Terms:

Interest Rate: The note accrues interest, which is added to the principal and converted into equity.
Maturity Date: A date by which the company must either repay the note or convert it into equity. If the company hasn't raised a new round by this date, the note holder can force a conversion at a pre-determined valuation.
Valuation Cap and Discount Rate: Similar to a SAFE, a convertible note often includes a valuation cap and/or a discount rate, giving you a more favorable conversion price than new investors.

Pros for Investors:

Downside Protection: Since it's a debt instrument, you have a liquidation preference in the event of failure.
Maturity Date: The maturity date provides a forcing mechanism to resolve the investment if the company is not growing as planned.

Cons for Investors:

Complexity: Convertible notes are more complex legal documents, often requiring more time and money to negotiate.

3. Priced Equity Round

A priced equity round (e.g., Series A, B, etc.) is when a company sells a specific number of shares at a specific price per share, based on an agreed-upon valuation.

How it Works: Investors purchase a specific class of stock, such as Series A Preferred Stock, with well-defined rights and preferences. The investment is direct equity, meaning there is no future conversion event.
Key Terms:

Pre-Money Valuation: The valuation of the company before your investment.
Post-Money Valuation: The pre-money valuation plus the total amount of new investment.
Share Price: Calculated by dividing the pre-money valuation by the number of pre-existing shares.

Pros for Investors:

Clarity: You know exactly what percentage of the company you own at the time of the investment.
Standardization: The legal documents for priced rounds are well-understood and are the standard for later-stage investments.

Cons for Investors:

Complexity and Cost: Priced rounds are the most expensive and time-consuming to execute, with significant legal fees for both the company and the investors.

The Term Sheet: Decoding the Fine Print

A term sheet is a non-binding outline of the key terms of a deal. It's the blueprint for the final, legally binding documents. Here are some key terms you'll find, including the critical concept of pro-rata rights.

Valuation: As discussed above, the valuation is a critical term that determines the price per share and, therefore, your ownership percentage.
Liquidation Preference: This is a powerful term that gives investors a priority claim on the company's assets in the event of a liquidation (e.g., an acquisition or failure). A 1x liquidation preference, for example, means you get your money back before any other investors receive a return.
Anti-Dilution Provisions: These terms protect investors from dilution if the company raises a future round at a lower valuation (a "down round").
Pro-Rata Rights: This is one of the most important rights for an angel investor. It gives you the option to invest in a subsequent funding round to maintain your ownership percentage. Why is this so crucial? Because if a company is doing well enough to raise a new round, you want to invest more to prevent your equity from being diluted. This right ensures you have the ability to do so, maximizing your exposure to the winners in your portfolio and capturing more of the upside.
Board Seats or Observer Rights: The right to have a representative on the company's board of directors or, more commonly for angels, the right to attend board meetings as an observer. This gives you valuable insight into the company's progress and strategic decisions.

Conclusion

Understanding investment vehicles and term sheets is non-negotiable for any serious angel investor. The type of vehicle (SAFE vs. Convertible Note vs. Priced Round) dictates the timing, complexity, and risk/reward profile of your investment. However, it's the terms—especially valuation, liquidation preferences, and pro-rata rights—that truly determine the economic outcome of your investment. By becoming fluent in these concepts, you empower yourself to not only make informed decisions but also to protect and grow your capital over the long term.