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!

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.