Ask the attorney: What sort of stock should I give my angel investor?

(Editor’s note: “Ask the Attorney” is a weekly VentureBeat feature allowing start-up owners to get answers to their legal questions. Submit yours in the comments below and look for answers in the coming weeks. Author Scott Edward Walker is the founder and CEO of Walker Corporate Law Group, PLLC, a boutique corporate law firm specializing in the representation of entrepreneurs.)
Question:  We launched our company about six months ago, and we have a couple of angel investors lined-up for about $300,000.  We don’t know if we should sell them common stock or preferred (they want preferred).  I’ve read some stuff on the web that recommends issuing convertible notes.  What do you recommend? Thanks!
Answer: This issue comes-up all the time.  Short answer: I recommend that you issue convertible notes.
Long answer: There are advantages and disadvantages to each of the options from the founders’ perspective.
Common Stock: The advantage of issuing common stock is that it is relatively quick, simple and inexpensive.  All you need is short subscription agreement and perhaps a stockholders agreement (if you don’t already have one).  In addition, from the founders’ perspective, it puts the angels in the same boat as them.
There are four disadvantages to this method, though. First, you’ll need to value the company, which (as discussed below) can be difficult and may lead to a substantial dilution for you. You’re also likely to get substantial push-back from sophisticated angels — who generally will not agree to common stock because they don’t think their money should be in the same boat as the founders.
Additionally, there may be tricky tax issues depending upon the timing of the investment. For example, if you and your co-founders paid a nominal price for your shares of common stock and the angels pay substantially more for theirs shortly thereafter, the IRS may question how the value of the stock could have increased so much and may deem the shares issued to the founders a form of compensation. Finally, it may cause potential problems with respect to stock option grants because the value of the shares of common stock will be established.
Preferred Stock: Preferred stock is extremely favorable to the angels.  The only advantage from your perspective is that the interests of the founders and the angels are aligned.  Specifically, there is no incentive on the angels’ part to keep the valuation of the company low in the Series A round. (Whereas, if they hold convertible notes, they might want to do so. More on that in a second.)
The disadvantages to issuing preferred stock are significant. It’s relatively time-consuming, complicated and expensive. Legal fees can be in the neighborhood of $20,000 or more if the preferred stock has all the “bells” and “whistles”.
And, as noted above, valuing the company at such an early stage is difficult and often leads to protracted negotiations and substantial dilution to the founders.
Convertible Notes: The issuance of convertible notes is often viewed as a reasonable compromise between issuing common stock and issuing preferred stock.  In essence, it’s a form of “bridge” financing that’s designed to provide the company with sufficient funds to get to the Series A round, at which point, the notes would automatically convert into preferred stock at a discount (e.g., 15 percent –35 percent).
The advantage of issuing convertible notes is that it is a relatively quick, simple and inexpensive process. All you arguably need is a short note.  Also, it will defer the company’s valuation until the Series A round.  By issuing convertible notes, you “kick the can” to the Series A round, at which point the valuation picture would be clearer.
The disadvantage of issuing convertible notes is that once again the founders’ interests and the angels’ interests may not be aligned because, it’s in the angels’ interest for the Series A valuation to be low.
Some angels who think they can make a significant contribution to your company (as a result of their introductions or domain expertise, for example) want to share in the increase in value they are creating.  Accordingly, if the angels do agree to the issuance of convertible notes, they will often push for a “cap” on the Series A valuation – which is obviously not in your interest.
Disclaimer: This “Ask the Attorney” post discusses general legal issues, but it does not constitute legal advice in any respect.  No reader should act or refrain from acting on the basis of any information presented herein without seeking the advice of counsel in the relevant jurisdiction.  VentureBeat, the author and the author’s firm expressly disclaim all liability in respect of any actions taken or not taken based on any contents of this post.
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