By Paige S. Connelly and Cassandra W. Borchers from Thompson Hine
Why the uptick in angel fund formation in the startup community?
Investors are becoming increasingly interested in the opportunities and benefits of launching angel funds. With a growing community of startup companies in the tech and software as a service (SaaS) markets with high growth potential, investors are making seed stage investments a part of their involvement in the emerging company ecosystem. Angel investors can offer strategic guidance and wisdom to the entrepreneurs, who also benefit from the symbiotic investment relationship. For accelerators, incubators and investor groups looking to start an angel fund for the purpose of investing in startup companies, there are several key legal considerations that impact the process.
What does the legal structure of an angel fund look like?
The sponsor needs to determine the organizational structure of the fund and its management. A limited partnership or a limited liability company is a common choice for the fund entity. Many institutionally backed venture capital funds are limited partnerships, and many seed stage investment funds follow this format as well. The limited partnership structure includes a general partner entity, which may serve as the management company for the fund unless a separate management company is engaged. The investors are limited partners and as such, have no role in the management of the fund. However, the fund may grant certain key investors advisory board roles. It’s important to keep the management function separate and localized within the management company. The management company is often organized as a limited liability company or a C corporation and receives all of the fees in connection with the management of the fund. The management company will typically employ a portfolio manager to analyze investment opportunities, negotiate the terms of the transactions and direct the capital investments. Limited partnership interests should be targeted at investors with experience in the angel community who have done their due diligence on the type of investments that the fund will make.
The fund will be a for-profit entity, and in the event of any affiliation with an accelerator or incubator that is a non-profit entity with tax exempt status, it’s important to consider the impact of applicable tax law in structuring the fund and related entities. The fund should be organized, governed and managed completely separately from any tax exempt entity due to restrictions on the investment activity of non-profit entities.
What are the legal considerations and questions to ask when launching an angel fund?
It’s important to consider how many investors will invest in the fund, whether the investors will be accredited or non-accredited investors (as defined in Rule 501 of Regulation D under the Securities Act of 1933), how much capital the fund will raise and what types of investments the fund will make. These components impact the offering structure and applicable securities rules and regulations, which will dictate certain matters related to fund compliance.
Who should be limited partners of the fund?
The initial benchmark for purposes of determining whether certain securities exemptions for a private offering will apply is whether the fund will be offered to non-accredited investors. While exceptions may permit sale to 35 or fewer non-accredited investors, such sales may impact which private offering exemptions are available, and what information must be provided to non-accredited investors. In addition to the impact of securities rules, it is important to consider the business consequences of allowing non-accredited investors to join the fund. Many experienced angel investors prefer to invest alongside other accredited investors, and in order to attract a sophisticated membership base for the fund, it may be desirable to restrict the fund to only accredited investors.
In which type of companies will the fund invest?
Many accelerators in the emerging company space focus their efforts on scalable SaaS and tech companies with high growth potential, and angel investors seem to follow suit. On the other hand, some accelerators target companies whose business models are in line with the organization’s mission, which may include minority- and women-owned businesses, social impact companies, lifestyle businesses and regionally-based businesses. It’s important for the general partner and manager of the fund to identify the type of company investments that will be permissible, and to formulate an investment strategy for the fund as well as the criteria to be used to evaluate and select startup candidates for these investments.
What type of investments will the fund make in startup companies?
The most common types of early stage investments in startup companies are convertible debt transactions and preferred equity investments. Convertible notes are loans that can convert into preferred equity issued in the company’s next qualified equity financing round. The note can also provide for contingencies and specify what happens to the note if it matures before conversion into equity, or if the company enters into an exit transaction prior to conversion. Convertible notes and, more recently, simple agreement for future equity (SAFE) and keep it simple security (KISS) instruments are commonly used in angel investing. Some investors prefer to invest directly in an equity security and will wait for a startup company to have a Series Seed or Series A preferred stock offering before the investor will invest. Convertible note financing transactions can be simpler, quicker and less expensive to close because they typically involve less negotiation and integration of investors’ rights and preferences into the corporation’s governing and organizational documents. Investors who want to invest directly in a preferred equity security often desire the certainty of establishing the price per share of the preferred stock at the time of the transaction, as well as the rights, preferences and privileges they will have as a holder of preferred stock. For each of these types of transactions, it is important to connect with counsel to discuss the applicable documentation, offering materials and relevant securities requirements and filings that are components of the transaction.