From the Collective

Your Legal Checklist For Angel Investing

Mallun Yen

Angel investments can give promising companies critical initial momentum, and it’s been shown to continue propelling them forward in several ways: they’re more likely to raise subsequent VC funding, they typically have 30-50% growth in critical metrics, and they benefit from strategic introductions their angel investors make. And while investors are creating more entrepreneurs, a Wharton/Harvard study showed entrepreneurs are also creating more angels. In a climate where taking action against bias and inequities is a mandate for so many, angel investing is emerging as a powerful tool for creating positive change as well.

We tapped Operator Collective LP Einat Meisel, a partner at Silicon Valley law firm Fenwick & West, for some core legal fundamentals to keep in mind as you consider angel investing. This is the first installment of the _So You Want to Be an Angel _series, a resource for members of our community who want to explore angel investing. 

✔ Make sure the startup has a proper legal structure 

Most startups organize as a C-corp or LLC in Delaware or California. It’s important to confirm the incorporation has happened as it gives angel investors important legal protections. Investing in other structures (e.g. partnerships) have important tax and liability implications that should be carefully examined before investing. 

✔ Make sure the IP is actually owned by the company

For most early stage companies, intellectual property (“IP”) is the key asset. It’s vitally important that the IP is assigned and owned by the company, including pre-incorporation IP. Asking to see founder and employee assignment agreements can help the angel investor assess IP ownership issues. Be aware that IP can come from myriad sources: employees, third-party contractors, customers, and more. The longer a company has been around, the more entangled the web of IP can be.  

✔ Ask the cap table question

A capitalization (aka “cap”) table is the list of the company’s shareholders and the people who have rights to equity. At the very early stages, capitalization is usually straightforward because companies have not raised money from a lot of sources. Inquire about how equity has been allocated, who owns it and what rights attach to that equity. This will give you an understanding of the community that’s supporting the founders, as well as an understanding of the special rights or issues that exist with respect to that equity. While angel investors should ask to see the cap table, it’s not uncommon for founders to keep details of the cap table close to the vest in angel rounds. 

✔ Ask legal compliance questions

Having a look at the company’s employment practices and assessing their understanding of securities law is deeper diligence that some angel investors do. Employment law violations such as misclassifying employees and contractors or failing to get a valid securities law exemption with every equity issuance could create headaches for everyone involved down the road. 

✔ Explore possible tax gains 

Angel investing is risky business, but one huge perk many investors are not aware of is the tax gain afforded by the Qualified Small Business Stock (QSBS) Act. Essentially, QSBS allows angel investors to exclude from federal income tax 100% of the gain on the sale of certain qualified small business stock, limited to the greater of $10 million or 10 times the adjusted basis of investment. This tax credit could save you millions — but the regulation and criteria can get complicated so be sure to consult with your tax advisor to determine if your investment qualifies. It’s fair to say, however, that most early-stage investments in C corporations meet the QSBS criteria.    

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