Angel funding is a critical source of capital for early stage companies. This type of financing will typically raise from $100,000 to $1,000,000 – with even higher amounts coming from so-called “super angels.” Yet, at this early stage, startups are very hard to value and, consequently, to determine what percentage of the company’s equity should be issued to the angel investors for a given amount of capital. Accordingly, most angels will accept a promissory note (instead of stock) that is convertible into the first round of equity (Series A) at a discount from the price paid by the Series A investors. This discount, usually in the 20% range, provides the angels with the extra return that reflects the higher risk they took in making the earlier stage investment in the company. The assumption is that the Series A investment will be made by institutional venture capitalists at a later stage in the company’s development. By then, the company’s valuation could be determined more easily by the professional venture capital investors, based on their due diligence and the market comparables that they would take into consideration in making their investment decision.
The terms of the convertible notes to be issued to angels are very clearly defined. Indeed, most lawyers knowledgeable about angel financing, whether in Boston, Palo Alto or New York, use pretty much the same forms, containing essentially the same business terms. Given the startup company’s need for every cent it can get, there is typically minimal negotiation, as everybody is focused to keep legal fees low and the process of raising the round from multiple investors simple and streamlined. After all, who wants to spend the money and brain damage to negotiate separate terms with a dozen or more angel investors, each putting $25,000 to $100,000 into the company.
Once in a while, a “clever” angel decides that he or she wants a different deal. This angel will claim that this requested deal is the “market” and that the terms offered by the company are unacceptable. Sometimes, such an angel might even suggest that he or she has consulted with the other investors, and they all are requesting better terms. Our suggestion: drop the “clever” angel like a hot potato. Not only will that person cost a lot of money in legal fees and cause a delay in raising the angel round, but he or she will be forever trouble as an investor. There are few things worse for an entrepreneur than the prospect of having to deal with a majority shareholder who thinks that he or she is smarter, and can get a better deal, than anyone else. We consider “clever” angels as “fallen angels” – and of course there is an entirely different term for that type.