The actual structure created for a life science startup will not be substantially different from any other startup investment. Thus the following information is not specifically customized to the needs of the life scientist-entrepreneur.
Structuring an early stage investment can be seen from two perspectives. The first perspective focuses on the complexity of the structure. In general, this requires a simple, yet understandable agreement which is based on trust and mutual respect of both parties. The simplicity of the agreement is important because in most cases funding from the angel will not be the last funding. For both the founder and the investor it is important that the structure created at the outset is acceptable to venture capitalist in later rounds without significant modification.
The secondary component is the actual agreement terms. Structure includes more than ownership stake, though ownership stake is often the most important and most contentious issue, so it makes sense to address it first. The primary decision is between two choices. The first is offering the investor common shares and various rights that would likely accompany the common shares. The alternative is some type of preferred shares as well as the many possible rights that would be conferred alongside preferred shares.
Arguments for either can be made. Essentially, common shares will not confer many of the special rights available to preferred shares, yet common shares will be simpler to arrange. For a small stake in a company, common shares may be the easiest and most logical path to follow. The potential upside can be added through additional rights to invest in additional rounds as well as to sell when anyone else sells shares.
Preferred shares may provide additional rights related to board selection, obtaining dividends, obtaining internal information, making decisions regarding liquidation, or conversion or redemption of shares.
The final type of investment would be a convertible note which is more attractive currently. This avoids actual negotiation on the price and sets the share offering tied to a future event. The note is likely to be convertible into preferred stock and discounted to the rate of the actual sale of preferred stock as compensation for the additional risk that the angel endured. The advantage is that neither party must agree on a valuation at this time. At a later time, the financials will be more clear and the venture capitalist will likely be more skilled at valuation. The convertible note provides an incentive to gather additional funds via venture capital at a later time, and because of changes in the discount rate, the incentive is to obtain those funds earlier rather than later. Thus, if additional funding is not expected, this is not a logical path to follow.
The note includes the possibility that the investor would be repaid if additional funding is not received. However, in such a case it’s more likely that the company is not viable and all the funds would have been lost. If additional funds are not received then the angel has likely taken on a large risk and received a fairly meager rate of return on the note. Again, in such situations, a note is the optimal structure.
Additional important parts of the structure beyond the capital structure discussed above would be the expected involvement of the investor regarding participation in the board or acting an adviser. The structure should also include the expected time that the entrepreneur will be involved as well as the salary and expected time the entrepreneur will stay with the company. Finally, reporting (as with any contract) is essential and should offer financial information for the company as on a monthly and quarterly basis as well as significant expenses.
The entrepreneur should consider that a request for preferred shares will require a more complicated legal agreement to clarify the details and the investor rights. This also increases the time for the negotiation as well as the legal costs involved. However, to avoid confusion and disagreements later it’s logical to invest wisely regarding time and energy and ensure that the agreement is both sound and clear to both parties.
It can be a complicated and difficult series of decisions, but hopefully this helps with structuring early round investments in a way that best suits your life science startup.