Editors Note: This is the second of a two-part series about the pros and cons of angel financing. Walter Daniels is a founder of and principal in the Research Triangle Park law firm of Daniels Daniels & Verdonik, P.A.There are always two sides to every story but the truth is, folks, all angels ain’t.

The story goes something like this. Most growing companies need cash. Most entrepreneurial companies don’t have enough cash. Most early stage growing companies won’t be considered by venture capital firms and other institutional investment sources for many reasons. Hence many entrepreneurs hope and pray for an “angel.”

An angel is supposed to be a wealthy individual, perhaps an experienced business person, who takes an interest in the entrepreneur and the young company, who makes capital investment in the company long before institutional players are interested, and who may serve as a principal advisor to the company. Contrary to the wishes of some entrepreneurs, angels are not “dumb,” passive investors; nonetheless, true angels wake up in the morning on the same side of the fence as the entrepreneur, are in essence “entrepreneurs half-removed,” and for the most part are willing to share the same risk profile as the entrepreneur. The presence of angels is absolutely critical to any thriving entrepreneurial community.

In sum, angels are good, entrepreneurs love them, and there aren’t enough to go around. If you are an entrepreneur and you find one, keep your mouth shut.

Notwithstanding the following admonitions to entrepreneurs, the author has spent much of his professional career promoting the development of a knowledgeable and robust angel investment community in the Research Triangle and elsewhere in North Carolina, since without angels many of our region’s most promising young enterprises would have died for want of well deserved early stage capital. On the negative side, it is not true that all good deals get funded–many promising companies in this region have in fact died or limped along for want of such early stage capital. Make no mistake about it, angels are important for North Carolina’s future.

The old days

In the old days the angel would buy stock in a company and perhaps also make a loan to the company. Normally the stock purchased would be common stock and in many cases the loan would be unsecured (because if there were adequate security the entrepreneur might be able to get a bank loan). The relationship was based on belief in the entrepreneur and trust. Most of these transactions involve anywhere from $10,000 to $250,000, although sometimes more is invested. This is in contrast to venture capital transactions where in most instances $500,000 is the smallest investment, and the investment is documented with inches of paper involving complex preferred stock instruments, anti-dilution provisions, negative controls (i.e., “you can’t do x, y or z without our approval”), and rights to take over control of the company on the downside.

Here’s where the plot thickens. In the scheme of things “venture capital” is still new to North Carolina. Although the first formal traditional venture capital funds in the state were created approximately twenty-five years ago, most of the venture transactions in this State have occurred in the past eight to ten years. Many lawyers and individuals are enamored with being involved with “venture capital” transactions. Unfortunately, many small transactions that would formerly be angel transactions are being documented as “mini-venture capital” transactions by lawyers trying to show their documentation prowess on behalf of individuals who are basking in being “sophisticated investors.”

The party line seems to be of course the angel is a prudent business person and of course the angel must take steps to protect himself. The entrepreneur who is desperate for cash looks to his left, looks to his right, looks behind him, sees no one with his wallet open, takes a deep breath, keeps a straight face and, of course, signs the papers. The papers signed reflect documentation for a small deal as it were a big deal. If the investor is truly an angel there is probably nothing wrong at this stage, even if the transaction is over-documented.

The wolves

But some would-be angels prove to be wolves in sheep’s clothing. The first sign of trouble shows up when the angel investor says: “there’s no need for a lawyer–we’ll draw up the papers to save money.”

A second warning sign may occur when, after the transaction, the angel investor wants to replace the traditional advisors to the entrepreneur–the accountants, lawyers and directors–with individuals who have a relationship with the investor. This may occur as a result of coaching or it may occur as a result of taking control, directly or by coercion, of the board of directors. Once the entrepreneur is severed from his traditional lines of protection, the feasting begins.

The parade of horribles that may follow include some or all of the following (I am not making these up, these all come from real situations)– all, of course, taken “in the best interests of the corporation” and all, of course, being duly documented:

One: “Cram downs” are effected where massive amounts of new stock are issued for relatively small amounts of new capital, resulting in diluting the interest of the founders to a tiny fraction of their initial holdings;

Two: The founders are fired;

Three:Consulting contracts and stock option agreements are set up for the investor and his cronies that siphon off value from the company;

Four: Assets securing loans are sold off at fire-sale auctions and picked up by the investors; and,

Five:The “troubled” company is merged into another company in which the investors have an interest on terms that leave little value for the founders. This is a short list which is by no means comprehensive.

Other disguises

Another form of angels being devils in disguise shows up in the form of wealthy individuals who guarantee loans. In many instances the individual puts up no cash, provides a guarantee for a small bank loan, takes a small amount of warrants to purchase stock in the company in exchange for making the guarantee, and gets a lien on all of the assets of the company. This all seems innocuous until, as will invariably occur, the company needs more money and in order to effect a new transaction the consent of the guarantor is required. In addition, the guarantor may need to subordinate his position to that of the new funding source. It is at this time that the squeeze occurs and the guarantor may end up with an equity or warrant position in the company greatly disproportionate to the risk taken, and in many instances, without any cash having been put into the company.

Indeed, there are many times when real risks do materialize and drastic action on the part of the investor is proper. Reasonable investor protections are appropriate. It’s a tough world out there and sometimes entrepreneurs should have to take a lump. It is, however, very important for entrepreneur to do due diligence on the investor prior to making any commitments and for the entrepreneur to make sure he has proper professional advice on any investment transaction.

This is because, of course, all angels ain’t.

Part One: www.localtechwire.com/article.cfm?u=7719

Daniels Daniels & Verdonik, P.A. has been serving the legal needs of entrepreneurial and high technology clients for more than 20 years. Walter Daniels concentrates his practice in the representation of rapidly growing companies, most of which are technology-based. He serves on the Board of Directors of the Council for Entrepreneurial Development and the Statewide Advisory Board for the North Carolina Small Business and Technology Development Center. Questions or Comments can be sent to wdaniels@d2vlaw.com.