The end of an angel investment: from the magic to tragic

There are lots of articles about angel investment and its role in (https://www.foundercatalyst.com/blog/from-unicycle-to-unicorn-your-funding-journey), but relatively little is written about how these investments can end.

Most of the time, founders and investors' interests are naturally aligned. There are some ridiculously good ways of exiting, where both parties end up winners. There are quite a few bad ways, which are painful for one or both sides. And then, there are a handful of off-the-charts catastrophic outcomes, some of which have happened to me or people I know.

We’ve pulled together real-world examples to give you a better idea of what happens at the end of an angel investment.

Before we start, you should be aware that angel investing is an illiquid asset class: returns are 7+ years off, probably and once you’ve invested there are rarely any ways of accessing your investment money until you have an exit of some kind – or the company collapses and you benefit from the loss relief afforded by SEIS and EIS.

Interested in understanding what an expected angel portfolio return is? We’ve got an article on just that topic.

So here we go, from the great to the very grating…

The best outcomes for an exit

A trade sale

A trade sale is where the business is acquired, usually by a larger company in the industry, which buys all of the shares. It's the most likely exit scenario and usually works out well for both founders and investors (read on for the big caveat!).

The founder may have to 'rollover' some of their proceeds, so they might get some cash and equity in the acquiring company. Investors usually get out 100% scot free, and having recently gone through a trade sale myself, it can be a very, very good day for investors.

We had deferred consideration, where the founders had an earnout in the exit, but some of the investors’ payments were subject to this provision too. We had half the payment upfront which gave us a 5x exit, and if the founders hit the earnout target then we got another 5x our investment.

...but an acquisition can be problematic

The caveat is that acquisitions don’t always benefit angel investors. One example is an early exit, where a start-up decides to exit within three years of your SEIS shares being issued to you.

If that happens:

• There would be no disposal relief on any gain that arises on the disposal
• SEIS income tax relief would be wholly or partly withdrawn
• Any gains made on the disposal would be chargeable to Capital Gains Tax (CGT)

I’ve experienced this myself, where one start-up I backed tried selling within three years (frustratingly, the deal was on the table after two years and 10 months).

If they’d sold, I would have had to pay back 50% of my money to HMRC and also pay CGT on an exit, so I asked them to wait for two months. They refused and wanted to push ahead with the transaction.

If you don’t like the look of a deal as an investor, you can be forced to accept the terms in what’s known as a drag-along. A founder usually has to get more than 80% of people who have shareholdings to agree to a deal. If you own 2% of the business, you can’t veto the sale, so you get “dragged” through the transaction, which is as harsh as it sounds.

If that happens, you do have a soft veto in your arsenal as an investor – you can just refuse to sign anything related to the transaction, which makes it really painful for everyone involved and creates a risk that the acquirer would inherit. For this reason, it’s fairly rare for an acquirer to buy a business where a shareholder needs to be dragged through the transaction, refusing to sign anything at all.

Private equity investment

Private equity is a good example where outcomes for investors and founders differ. You can have a private equity transaction where the existing investors get out and keep their SEIS tax relief, and the founder continues in the business with a new investor.

Private equity transactions usually involve buying out every single investor, so it’s a great day for investors as long as it’s after the three-year window mentioned above. There may be a tickle for the founder too where they end up with half a million quid or something like that, but private equity tends to be more favourable for the investor side.

The company goes through an Initial Public Offering (IPO)

An IPO is another attractive exit route, where a business offers to sell shares to the public on a regulated investment exchange like London Stock Exchange’s AIM.

The number of start-ups that go public is increasingly small, so this will be pretty rare for angel investors. It’s only a possibility for exceptional rocketship companies like Darktrace, Brewdog, Starling Bank and so on (where if you invested right at the start then you’re going to cling on for dear life!).

Secondary sales of shares

Sometimes late-stage investors will buy shares from earlier-stage investors, which is known as a secondary sale.

It’s not an exit for a founder, but it’s not a bad outcome for investors. If you’re an SEIS investor and your investment has passed the three-year mark, then an offer to exit at a fair multiple of your original investment might be appealing.

There are also secondary markets where you can openly sell shares, such as Seedrs’ Secondary Market, but these have never really caught momentum in the UK.

First, they don't benefit the company – as an investor, I’m getting the cash rather than the business. Second, if it’s an angel investor buying my shares, they can’t benefit from SEIS/EIS, so why not just buy shares from the company and get the benefits there?

The company buys back shares

A good exit (but one that nearly never happens) is the company buying back shares. A founder might think that they’re going to build a business which has £10 million a year in profit and then buy back existing investors.

What they fail to realise is that if you’ve got a business with £10 million in profit, the 10% of shares you’ve sold are going to be worth much more.

So, while it’s a good option for investors, it’s virtually unthinkable that the economics would work in a way that meant a company could buy back shares and make commercial sense to an investor. You’re also not allowed to agree to this upfront, because it’s not compatible with SEIS/EIS rules.

Bad outcomes for an exit

A collapse, but in the right way

The reality of investing in early-stage EIS (and particularly) SEIS companies is that they have a high chance of failure. Take the statistics with a pinch of salt, but the reported figure is that 50% of start-ups fail within five years.

This collapse might come from:

• The start-up running out of money
• The founder throwing in the towel (I saw this recently – a founder did lots of funding rounds, over-diluted themselves and ended up owning only 10% of the company, so it wasn’t worth them being involved anymore)
• An inability to pay debts, so the business is forced into liquidation

For founders, a collapse will obviously fall into the “catastrophic” column. But for investors, it’s one of the better “bad” exit scenarios.

As long as you’ve got an SEIS3 form from the company founders, you can claim loss relief which will help to soften the blow. This applies even if the business is less than three years old.

Ending an investment on good terms even when things are going wrong: One start-up I backed was trying to sell into the military, which was never going to happen quickly. When the founder ran out of cash, he wrote to the shareholders, explained his decision to close down the company and filed all the things he needed to so we could claim relief. He did everything in exactly the right way and acted with such integrity that I would potentially reinvest in that founder.

The founder ghosts investors

Founder ghosting is where the founder stops giving updates, the website disappears and the company accounts stop getting filed, threatening a compulsory strike-off by Companies House.

It’s not a complete disaster for investors, because you can claim loss relief, so you’ll get half of your money back. But you can only claim loss relief once the company has been put out of its misery, so it’s certainly not a good day if this happens.

…and the wrong way to go about it: I invested in a company and found out it had been struck off by Companies House. The founders didn’t tell me they’d actually sold part of the company – I found out by accident. So, if those guys asked me to invest in their future business, I would run a mile.

The founder wants a lifestyle business (AKA a 'zombie')

This isn’t technically an exit, but some founders will decide that they want a lifestyle business where they take a salary and just run the business as it is, without exiting.

It’s clearly a bad outcome for the investor, because you’ve invested on the basis of an exit. You might have received some tax incentives along the way, but you’ll likely get no income and no exit, and you can’t even claim loss relief.

It’s not really possible to mitigate this risk either. Larger, late-stage investors may get drag-along rights that give them the ability to force a sale, but it’s almost unheard of for early-stage angel investors.

No investor wants dividends: Investors put money into a business to bring an idea to life, but they also want a substantial return on their investment. What an investor absolutely does not want is dividends – no angel investor wants £6.50 a month. If you’re a founder reaching out to investors, remember that talking about dividends is a massive turn-off. Don’t use those words. Ever!

The founder has their business stolen

While this isn’t usually a risk for investors, it's a really ugly ending for founders. In this event, shareholders push the founder out or replace them with a CEO, and the founder can end up with no shares or financial pay-off.

I spoke to one founder who unfortunately experienced this, losing control of their idea and then their business. They kindly let FounderCatalyst document their story, which is educational and terrifying in equal measure.

Very bad: A VC exit involving liquidation preferences

The – almost – worst case scenario for an angel investor is that later stage investors have liquidation preferences that destroy your outcome.

The case of fantasy sports company FanDuel is a cautionary tale, and an absolutely hideous one. The FanDuel founders bootstrapped, then did some angel rounds, then junior VC rounds and then the big boys of VC invested.

The business grew to about half a billion in revenue, but when things took a turn for the worse and its valuation dipped, the big VCs had two things that caused a real problem.

One issue was that the two lead investors had liquidation preferences which gave them rights to the first $559 million in an acquisition, so the founders would only get paid if the acquisition exceeded that amount.

The second was that the VCs had specific drag-along rights, which is very rare – I’ve never seen it personally – that allowed the VCs to force the sale of the business, irrespective of what anyone thought (which is obviously dangerous because most VCs are sharks). FanDuel was acquired for $465 million, which meant the founders and angels got absolutely nothing.

I’m sure you would still be able to get loss relief under SEIS and EIS in this situation. But the emotional sting of investing in a half-a-billion-dollar company and ending up with nothing puts it in the “catastrophic” pile.

The catastrophic outcome: collapse and no SEIS relief possible

Finally, the king of worst case scenarios for angel investors – and something that happened to one of my fellow investors.

For your investment to be covered under the SEIS/EIS schemes, you need to have an SEIS3 or EIS3 form. If the business collapses before you get that form, you’re effectively not invested under that scheme.

Normally, you’re risking 28% in a nightmare scenario, but here you’re risking all your money. You don’t get half your money back or any tax relief or loss relief. Without that form, it’s just like investing outside of the SEIS/EIS schemes.

This risk is exacerbated by using an advance subscription agreement (ASA), as we explore further in our article: the startup can only file and (S)EIS1 once your ASA converts. With an average ASA life of 6 months, this means that your window of risk increases dramatically.

A novel alternative

If you’re an angel with a limping / zombie investment then finding an exit for an illiquid investment is a seemingly impossible task especially when your investment has fallen in value significantly below the price that you paid. However, there is a secondaries platform called planD that enables disaffected investors to exit their underperforming investments with their unique method of ‘exit via diversification’ - a way to crystallise an exit from highly illiquid underperforming investments which are tying up significant capital. This is a simple share swap- whereby the investor exchanges their illiquid shares for shares in their fund. This is good for the investor who now has shares in a diversified portfolio, thus mitigating risk associated with a single investment, plus the release of capital (albeit in the form of (S)EIS loss relief- assuming today's fair value is below where you invested) which can be recycled into new deals.

From the founder’s point of view, being able to offer this to disaffected investors means they can clean up their cap table and concentrate on getting the business on track, away from the noise of disaffected investors who often include friends and family. It also makes sense to act in the best interest of people who have supported you and your dream with their hard earned cash, not least because it’s the right thing to do, but also because angel investing is a tight knit community and it’s important to retain a reputation as being fair, especially if you ever want to consider fundraising again in the future.

Do founders need an exit slide?

There’s a lot of debate around exit slides and to what extent start-ups need to plan their exit. The thing is, when you’re looking for angel investment, it’s unknowable how you will exit. Everyone thinks they will succeed, but it's equally likely that the business won’t work out.

Sophisticated investors know that an exit slide is basically made-up hogwash, but what they’re looking for is a sanity check. They want to see that you’re not aiming to build a lifestyle business and that they’re going to get a return on investment.

If you’re targeting an acquisition in a few years’ time, they’ll want to see your thought process around it – who are the likely acquirers and what comparable transactions have happened in the past?

Oh, and HMRC dislikes an exit slide and they will potentially raise a query: The investor presentation indicates that the Company hopes to have an exit strategy within x years. As such please explain how this demonstrates long term growth as set out in the risk to capital condition per VCM8540. This is answerable, but best avoided.

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