One thing that happens in the law business (I imagine any business) is that you become too familiar with the subject matter. As a result, you may start to take it for granted that your clients see the world the same way you do. This thought was sparked because I had a start up client ask a bunch of great questions about angel notes into a future financing. At Foley we deal with these kinds of angel notes all the time. For any given client, however, each note is likely to be a unique experience. Anyway, it is nice to be caught up short and look at some of the issues inherent in these notes afresh.

Basically, the client asked one of the questions I have addressed from time to time: What is normal? Are there usual and customary standards for --- you fill in the blank. She wanted "practice" guidelines for (1) What happens if there is not a future financing? (2) Are angels ever cashed out when the contemplated next financing happens? (3) Is there any way to translate the note into a percentage ownership in the company? (4) Is there a standard discount?

All of these are great questions. My first point is that clients should always be encouraged to ask these and other questions. If you don’t ask, I don’t know what your issues are.

With respect to the answers:

If there is not a contemplated future round, the note either becomes due and payable or converts into some existing class of equity. Now the issue that looms in the background is that something bad has happened (or something good has failed to happen). Also, the company may not have the funds to repay the note. So, to cover off this risk, the entrepreneur often (almost always?) negotiates to have the note convert into an existing class of stock (often, but not always) common stock. The down side is that the investor will want a highly dilutive conversion rate to compensate for the fact that they are making an investment that has turned bad.

Angel note holders are almost never cashed out because (1) angels don’t invest for interest rates of return and (2) start up companies rarely have the cash available for such a payment.

There is no way to translate a note that is convertible at a discount to a future round into a percentage of the company today – unless you put a collar on the conversion rate so that you can say the rate will not be less than some amount. In this case, you could calculate the maximum dilution. In 23 years of practice, I have seen collars used only once in the context of angel investing. The real answer is that the main virtue of these types of convertible notes is that they do not establish a valuation for the company. This decision is left to a hypothetical future investor.

And the big one, there is no standard discount. In my experience, the mode is 10 or 15 percent, although there are plenty of deals done with larger discounts and some (not as many) as a smaller discount.

I am always looking for a good question. Here were four.