In last month’s post Why Not More Startup Success Stories, reader Jeff offered an interesting idea where institutional investors would be encouraged to buy 10% of the equity from the angel investors, assuming they’d be interested in selling. For most startup communities, there are very few exits resulting in long/indefinite delays before angel investors receive a return on their money and thus the rate at which returns are recycled back into the community is limited. If institutional investors more routinely bought a small stake from the angel investors — say 10% — that’d generate angel returns faster and allow institutional investors to buy a larger piece of the startup.

Here’s how it might look:

  • Angel investor buy 10% of the startup for $150,000 resulting in a $1.5 million post-money valuation
  • Startup achieves strong traction and raises a $3 million Series A at a $7 million pre-money ($10 million post-money)
  • Institutional investor that’s buying ~30% of the company (less the pro-rata from any existing investors that want to invest more) is willing to increase their investment up to $3.14 million such that the existing investor that owns 10% before the financing round can sell up to 20% of their stake which represents up to 2% of the company (10% ownership of the $7 million pre-money represents $70,000 for one percent) for $140,000 thus nearly recouping their initial investment while still having 8% of the company remaining (pre Series A investment)
  • Post Series A investment, and after selling 20%, the angel investor now has 5.6% of the company (8% diluted by 30%, not counting a potential increase in option pool)

The institutional investor would want the angel’s equity reclassified as the same type of equity as the Series A otherwise there might be a discount.

By encouraging institutional investors to buy a small piece of the existing equity held by the angel investors, angels are more likely to invest in other startups and capital will be recycled faster in the community. Entrepreneurs should consider asking institutional investors about this when raising capital.

What else? What are some more thoughts on the idea of encouraging institutional investors to buy a small amount of equity from existing angel investors?