The Importance of MFNs in an Extended Bridge Phase World

Convertible note and SAFE financings remain the most commonly used instruments to bridge a start-up to its first preferred stock equity raise. Given the changing landscape around Series Seed and Series A rounds, in particular, a well-documented rising of the bar from VCs on “equity round ready” companies, more than ever before, start-ups are relying on these type of investment vehicles as a lifeline to raise capital for an increasingly extended period of time. The challenge for a start-up is how to rely on these vehicles, often accompanied with discounts and valuation capped rates of conversion, without giving up a disproportionate amount of equity at the ultimate conversion but, at the same time, continue to entice new investment from angels and early stage funds through the bridge phase. Some of those non-economic levers utilized by a company might include, to name a few, pro rata preemptive rights, guaranteed “major investor” status in the equity round, pre-equity round information rights, etc.

Accordingly, from an early investor’s perspective, there has developed an increased risk that your note will look a whole lot less favorable than the notes issued by the same company in connection with subsequent note financing rounds. To protect against that risk, I also encourage my investor clients to require inclusion of a Most Favored Nation, or MFN, provision in their note at the time of investing. If written thoughtfully, the MFN has the effect of giving investors the right to amend the terms of their existing notes to incorporate those additional rights and/or benefits (not just economic), which the company may introduce in the context of subsequent raises.   

But a word of caution for you investors relying on a MFN, particularly the off-the-shelf MFN found in the form YC SAFE, if written poorly or without customization, there is a strong chance the insurance that accompanies the MFN right may be worthless. So watch out!

NVCA Model Docs....times are a changin'

For the first time since 2014, the National Venture Capital Association, or NVCA, has updated its model financing documents to reflect a handful of key updates in order to account for the changing world over the past 4 years. In particular, two updates really stuck out which emphasize the times we live in:

Blocks on Crypto-Currency offerings

A new protective blocking right has been added to the model charter to provide investors a veto over token, crypto-currency and block chain related offerings given that the pre-existing veto rights did not clearly apply to or cover these new types of offerings. Without the change, existing investors may have been exposed to a portfolio company circumventing the standard block on future financings by pursuing alternative crypto offerings.  
 
Anti-Harassment/Code of Conduct

A covenant has been added to the model IRA that requires the company to adopt a code of conduct governing appropriate workplace behavior and a policy prohibiting discrimination and harassment at the company. Previously, the covenants contained in the form financing documents had never gone so far as obligating the company to adopt employee handbooks, particular policies, etc. To ease the pain and cost for companies, the NVCA published a sample HR policy to address this point. This is a welcome change for the tech/VC industry and emphasizes the issues that have plagued the community the past couple years.

Kudos to the association and its general counsel advisory board!

The Convertible Noteholder Standoff

For founders, raising that first equity round is a true milestone. It is not only an opportunity to bring in meaningful dollars from professional investors to fuel a start-up’s growth but, if you have had outstanding notes running interest since the early days coming out of inception, it also serves as a chance to clean up your company’s cap table by converting outstanding convertible instruments in connection with the round. With angel investors’ broad adoption and comfort of investing into early stage companies through convertible instruments, companies are delaying the need to sell preferred stock in an equity round, in some cases, for the first couple years of a company’s development. The fallout from this reality, however, is that when you do head toward closing that first equity financing, a founder will have the task of coordinating with the (sometimes, many) noteholders in connection with the conversion of those noteholders’ outstanding notes.

With a syndicated noteholder base, the risks of holdout (or unreachable) noteholders is elevated and without collection of all signatures from that constituency in connection with the equity round, the new money investors in the financing will inevitably be spooked. To combat the potential negative effects and risks of a “standoff” down the road at the time of the equity financing, initially when preparing and issuing your convertible notes, your counsel should be advising you on the appropriate language to include in the instrument to ensure there is zero room for interpretation in the event the noteholder does not provide its signature at the time of a triggering financing and resulting automatic conversion. Without an air tight documented mechanism, you will otherwise risk taking the “automatic” out of automatic conversion and open up potential delay in the closing of you ever-so-important equity financing.  

Amending Convertible Notes in connection with a Qualified Financing: A Word of Caution.

For some time convertible notes have been, and remain to this day, the preferred vehicle for an early stage company raising initial capital. A known commodity in the marketplace, the barriers and expenses of closing note bridge rounds continue to be less than opting for the sale of an equity security. What early stage investors might not be aware of, however, is a trend gaining steam of late – as company valuations increase in earlier investment rounds, a growing number of sophisticated lead investors in “Qualified Financings” (ie the company’s equity financing that triggers conversion of the notes) are applying increasing pressure to condition their investment in the round on the company amending the terms of their outstanding convertible notes to carve back a portion of the economic windfall received by noteholders in the Qualified Financing.

Setting the stage: The terms of a vast majority of convertible promissory notes in the marketplace provide that a note investor’s principal (plus interest) under a convertible note will, at a Qualified Financing, convert into the security sold in the Qualified Financing (ie Series Seed or Series A preferred stock) at the lower of (i) a discount to the price in the Qualified Financing or (ii) a pre-negotiated capped valuation.

The economic problem: Particularly in early friends and family note rounds, the pre-negotiated capped valuations are often times significantly lower than the valuation in the Qualified Financing. If the terms of the note are honored as-is, note investors would get the benefit of receiving not only the actual dollars (plus interest) invested under the note in the form of the same shares issued in the Qualified Financing, but also the (in most cases, material) discount premium as a result of the discount or capped price. This became known as the “phantom liquidation preference problem” – referencing the layered liquidation preference received on the lot of shares which had been converted into as a direct result of the cap piece of the conversion. 

The Lead investor’s fix: Condition the closing of the Qualified Financing on the company obtaining the requisite approval from their noteholders to amend the notes to either (i) convert the discount portion of shares received in the round into common stock, as opposed to preferred stock or (ii) convert into a shadow series of preferred with the same rights as the preferred stock sold to new money investors in the Qualified Financing with the exception that the liquidation preference on the shadow security is carved back to the conversion price at which the notes converted in the round.

The note investor’s dilemma: Either (A) don’t approve the amendment and the company you are invested in doesn’t receive the capital to continue operations or (B) approve the amendment and lose out at the deal originally bargained for which credited the note holder for making a risky investment in the first place.

The Conclusion for early stage investors: The lead investors in a Qualified Financing wields significant power in setting the terms for the new money round, which includes potentially forcing early note investors to adopt alterations to their initial note conversion deal. As an early stage note investor, however, there are precision drafting protections your lawyer can help institute at the time of the original investment which have the effect of returning at least some of the power back in the hands of a company’s earliest investors at the time of conversion. In any event, don’t be naïve: the suppressed valuation cap you successfully negotiate for in your note investment documents, if left naked, may end up taking on a much different economic outcome than you originally bargained for.

Wire Fraud on the Rise… Could the VC Community Be Hit Next?

It has been widely reported that cyber criminals are hijacking real estate transactions by finding increasingly sophisticated ways to intercept and make alterations to wiring instructions being distributed between parties leading up to a real estate closing, resulting in the wiring party being duped into releasing funds to an alternative (and often times, off shore) bank account. Over the last year, hackers are starting to apply the same techniques to prey on the venture capital community and financings transactions. Read here

This got me thinking about the standard practice for how venture financings are closed, specifically the process around how wiring instructions are shared between a company and its soon-to-be investors as well as the particular ripeness of the industry to be targeted by similar scams.  

It is customary that leading up to the final moments before a VC transaction closing, lawyers find themselves caught in the middle of coordinating distribution of final deal documents along with the company’s wiring instructions. Here’s how it typically unfolds: (1) a company will email its lawyers the company's wiring instructions to distribute along with executed documents and the filed charter, (2) the company's lawyers turn around and send a closing email, which contains those instructions, to the Investor’s lawyers, (3) Investor’s lawyers then forward along to their client with confirmation that the closing conditions have been met and the wire should be released. By my count that is 3 emails sent containing wiring instructions…. which is 3 emails too many!

It is time for lawyers to insist that the parties to a transaction take much more calculated steps to limit the risks associated with this particular style of cyber crime. Founders and VCs should communicate directly on wiring instructions, separate from the lawyers' deal document distribution, through secured means other than email and, prior to wiring any funds, the VC (or a member of their finance team) should contact the company by phone and confirm that the wiring information sent over email is accurate. In my experience, this isn’t common practice. But it should be.

Seed Investors: read this if you care about your pro rata!

Pro Rata Right to Participate. Preemptive Right. Participation Right. Call it what you may but this is one of the most important economic rights that attach to the preferred security received by a seed investor when making an investment into a portfolio company. For early stage investors, particularly those funds with limitations on their ability to cut larger checks to put them in the running to lead future rounds, preserving the right to participate in a portfolio company’s follow-on financing is paramount to future returns. Here is a word of caution for you seed stage investors (and your lawyers): Don’t risk being shut out of your participation right by missing a simple, yet key, technical drafting feature in your deal documents. The following anecdote sheds light on how that could happen:

Recently I was representing a VC in a subsequent round of financing for one of their portfolio companies. The round was being led by a strategic investor that had not previously invested in the company. My client and certain other existing investors planned to exercise their right to participate in the deal pro rata through a subsequent closing but, as is standard in financings, at the initial closing, existing stockholders, including my client, agreed to waive their contractual right to participate pro rata in the round, with the understanding that they would participate nonetheless. Note to the reader: This waiver is almost always solicited by the company, regardless of whether the company and new investor intend to honor the right of existing stockholders to participate, as it removes the need for the company to comply with the hoops and notice periods set out under the existing preemptive rights provision and, by doing so, a company avoids further delay on closing the current financing. Existing investors end up getting comfortable consenting to the waiver so long as the handshake business deal allows them to participate for an amount at least as large as what they were contractually entitled to had they not waived. 

So back to the deal I was working on….when the deal documents were distributed for final sign off, the lead investor had included language which would have subject participation in subsequent closings to that lead investor’s approval. Cue the lawyer’s alarm! With the participation waiver in hand at the initial closing and the lead investor’s ability to block who the company could accept as investors in subsequent closings, that set up a situation where existing investors could have technically been shut out of investing in the deal all together, in spite of the company’s desire to let them participate. Lesson for seed investors: ensure that your deal documents expressly carve out existing investors from lead investor’s block on who participates in subsequent closings, otherwise risk losing your ability to invest pro rata……and getting burned!

Getting ready for an equity raise? Read this if you want to save time and money on legal fees.

I am working with a handful of companies expecting to raise an equity round in the next couple months. In some cases, it will be a company’s first real fundraise, with prior investment coming through a bridge round (notes, SAFES, etc). In other cases, it will be a Seed-2 or A round. Regardless, It is a nerve racking time for a founder/management team and with everything else on your mind, ensuring your company’s books and records are in order from a legal perspective is most likely not high on the to-do list to prepare for the financing, but it should be. Here are 3 easy steps you and your team should be taking weeks before you execute a term sheet to ensure you will cut down on deal timeline and, most importantly, legal fees.

1) Start Populating your Dataroom

Often times your lawyers will have records relating to incorporation, stock grants, board consents, etc. but there are non-legal categories of information which your lead investor’s counsel will absolutely request in the course of their diligence which you or your team members will be better equipped to provide (as opposed to your lawyers), like, for example, commercial agreements with customers, financials, schedule of IP assets and descriptions of third-party source code that the company has incorporated in its products, etc.  A member of the team should be taking the time to organize, gather and populate the dataroom before the term sheet is signed so when the diligence request comes in from investor’s counsel, all you have to do is send the invitation. Leaving this task in the hands of your lawyer becomes inefficient and time consuming. So do yourself a favor, open up a dropbox account (a now totally accepted venue for investors and their counsel) and take control of creating/populating your dataroom. Not doing so will be costly.   

2) Start Collecting Information for Disclosure Schedules

One of the key tasks of a junior associate in connection with a financing is guiding the disclosure schedule process. Often they invite a kick-off call with the client early in the transaction process whereby the associate spends the time (and your company’s money) to hold your hand and give you instruction on how to populate the disclosures in response to the reps and warranties in the stock purchase agreement. Here is a secret - you can save yourself the pain of that call by going to NVCA’s (National Venture Capital Association) website, download the form Stock Purchase Agreement (for free) and read through the reps and warranties (Section 2 of the form Stock Purchase Agreement) in close detail before the term sheet is even signed. To the extent you have an exception to a rep or the rep calls for you to disclose certain information, jot that disclosure down (informally is fine) on a piece of paper. 9 times out of 10 the reps that make it into the Purchase Agreement in your deal will look very similar, if not identical, as the reps and warranties are rarely negotiated heavily in the context of an early stage equity financing. Hand that list of disclosures over to your lawyer and they will be impressed. More importantly, you’ve just saved yourself a 2 hour call (at least) with a junior associate after the deal is in full swing. Woohoo!

3) Start Cozyin’ up with your Cap Table

Arguably the most important step you can take to save yourself a big headache heading into your financing is knowing your current cap table inside and out. It is your chance to start your relationship off on the right foot with your lead investor and helps you and your lawyers with organizing for the diligence process and preparing for drafting deal documents, as well as your counsel’s opinion (which will mostly require your lawyers to opine on the number of securities you have issued up until the financing). So go down each cell in your cap table well before your financing, ensure everyone that has received equity is on there and that anyone who is on there is being shown as receiving the right amount. Sounds simple enough but I can’t tell you how many times lawyers are left with this job. And trust me, it can get costly.

Getting ready for your seed round? Don’t let your lawyers use these forms…

There is no question, over the past 10+ years, the trend in the industry has pushed companies and investors away from a more robust “Series A” round as a form of initial equity financing to a leaner “Series Seed” round. We almost take for granted now that a company can access much smaller (yet meaningful) amounts of capital, much earlier than they would have been able to, from established institutional investors willing to commit time and energy to a company and its vision. Over the course of that same period, the tech community became comfortable leaning a lighter set of customary legal rules, rights and obligations for companies and investors to live by as they navigate together toward the Series A round. This reality was spearheaded by Fenwick & West through their initiative to open source a set of financing documents called “Series Seed Documents”. The first version of the documents were made available in 2010. They had some kinks but overall they were industry changing. In 3 fairly simple documents (a charter, stock purchase agreement and investors rights agreement), they were able to establish a market standard for how to paper Series Seed rounds. For companies this was a huge deal as they had, up until that time, been forced to rely on variations of the full suite of NVCA Series A documents (a charter, stock purchase agreement, investors rights agreement, voting agreement and ROFR/CoSale Agreement) with lengthy rights and legal concepts which very rarely (if ever) came into play given the company's stage.

In 2013, however, the Series Seed forms took a bad turn. Fenwick decided to combine the stock purchase agreement with the investors rights agreement in one agreement called the Stock Investment Agreement. So you might ask, why would it be a bad thing to limit the paper work further from 3 to 2 documents? Well, I’ll tell you why. After closing your initial Series Seed round, not all companies experience the trajectory that allows them to follow-on with an immediate Series A round 1-2 years later. Instead, a large majority of my clients (and other seed stage companies) end up opting to put together a follow-on “Series Seed-2” round, typically to take advantage of raising additional capital, at a slight uptick in valuation to the Series Seed round, while leveraging the same defined rights/obligations set forth in the Series Seed round. And it is at this moment, after hanging up the phone with their client, that the lawyer runs into technical drafting issues. Whereas, with the version 1 Fenwick documents, amending those forms to layer in the Series Seed-2 security sold in the follow-on round was seamless and required only a small handful of changes to the already approved documents, with the version 2 Fenwick documents, specifically, because of the combination of the stock purchase agreement with the investors rights agreement, lawyers were left with only clunky (and I mean CLUNKY) ways to layer in a Series Seed-2 security appropriately.

So what is the solution? Hopefully Fenwick will address this issue and revert back to help standardize an industry around their original forms composed of 3 documents. Otherwise, you should pressure your lawyers to rely on alternative forms which have the flexibility to account for that follow-on Series Seed-2 round (even if you don't end up utilizing it). Anything otherwise would be short sighted.