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!

SAFES...the Death of the Convertible Note?

If you are a founder of an emerging company looking to raise money in a bridge round, you should hope the answer to that question is “yes”  for a few key reasons I will get into shortly. First a quick anecdote. I was meeting with a founder of a high profile tech start-up last week (not a current client) in Boston and he informed me that he was in the middle of raising a friends and family bridge round. My first question – what was the vehicle for the investment? When he told me a traditional convertible promissory note I asked him whether he had considered utilizing (or been advised by his counsel to utilize) the SAFE alternative.  I was shocked that his answer was a flat no. In fact he had never even heard of a SAFE. For those in the same position, start by reading this. Although over 3 years have passed since their creation out of YCombinator, SAFEs remain under used in east coast bridge financings. Here is why founders should want that trend to change:

No Maturity

Arguably the biggest headache for start-ups in a bridge financing is getting the maturity date wrong. If you do it can become a founder’s worst enemy, a logistical nightmare that turns a fairly inexpensive financing, into a more expensive one, as counsel is needed to draft documentation to extend maturity and founders end up needing to chase signatures from the requisite majority, all simply to extend a maturity date on an instrument that no investor ever expected to be paid back cash under. Not to mention all the question a founder starts receiving when they circulate that paper work to their investors. Oy. Safes do away with maturity all together and in doing so place an emphasis on the economic terms investors truly cared about when they decided to invest – namely mechanics for conversion and payment upon an earlier sale of the company.

No Interest

URGENT PUBLIC SERVICE ANNOUNCEMENT. To all those founders of start-ups raising a bridge round to its first equity financing, if your investors are making a stink in negotiations about the interest rate % or form of interest calculation (simple vs compounding) in the round, walk away. This is something that drives me crazy when I represent my early stage clients and something I always tell investors to drop first in a negotiation if they truly want to win the deal. You are investing in a start-up. The bet is that the investment will convert, not that you will make a bank like return on a loan. SAFEs do away with this conversation all together. Thank the lord.

No Phantom Liquidation Preference

Historically, when an investor’s principal plus interest under a convertible note converted at a discount or capped rate in connection with the triggering equity financing, that investor would get the benefit of receiving not only the actual dollars invested under the note in the form of the same shares issued in the next round, but also the (in most cases, material) discount premium. As a result, the bridge round investors were receiving what became known as “phantom liquidation preference” specifically tied to the lot of shares which had been received as a direct result of the discount/cap piece of the conversion. So why should founders care? Liquidation preference, in the most simple terms, is the amount of cash you would need to sell the company for before the common stock holders (founders and employees) saw a dollar in their pocket. Increasing the size of the liquidation preference, only distances the common from cashing in at a sale. Good news SAFES correct this problem by providing for conversion of the amount under the safe plus the discount premium into a shadow security with the same rights as the preferred security sold in the equity round but with a per share liquidation price equal to the lowered rate at which the safe investment converted.