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!

5 founder mistakes that keep your lawyer up at night

1. Giving away board seats to convertible note holder investors

Finding the right partner to invest in your business out of the gate is paramount to the success of a start-up (particularly) through its infancy stage. If your initial investors are conditioning their participation in your “friends and family” bridge round on receipt of a board seat, that should serve as a red flag. Your venture’s earliest investors, if experienced, should understand the fact that the founding team requires a maximum amount of flexibility at the board level as the company is coming out of inception and through its bridge financing. Adding an outside investor influence is more appropriate at the time of the company’s initial equity financing. Disrupting that equilibrium beforehand can cause problems for founders (too many cooks in the kitchen) and most importantly, may slow the company’s ability to achieve desired growth (forcing founders to chase after partially committed investors). And don’t buy the “but we want to help more than just giving you capital” argument. If that’s the case, set up a quarterly scheduled call or coffee meeting.

2. Issuing founders convertible note

Common Stock should be held by founders/management/employees and preferred stock should be held by investors. Any disruption of that fact inevitably introduces complexity as it relates to establishing an appropriate and unbiased governance structure of a company. For founders who have dedicated significant $ resources before outside capital becomes available, there is a temptation to “honor” that debt and roll it into the first convertible note round. The terms of that convertible note round, however, will undoubtedly have a conversion mechanism whereby investment in the convertible note ultimately converts into the preferred stock sold to investors in the initial equity round. Suggestion: instead of piggybacking the founder’s loan through that convertible note instrument, founders should consider documenting their loan instead as a straight promissory note (without a conversion feature) that would get repaid at some future trigger date.   

3. Not getting assignment of IP agreements from contributors out of the gate

This is one I see too often. At the time of engaging lawyers to legally form an entity that will house a product that you and your 2 other co-founders have been dedicating time to over the last 3 months, you get asked by your attorney to have everyone who has contributed to the IP of the company in the prior 3 months to execute an assignment of IP agreement. The problem: there was a 4th individual who was a part of the early conception stage but disappeared on you last week because they disagreed with the direction of the product build. Now they won’t answer your emails. The takeaway: if you are leaning on the contributions of individuals other than yourself out of the gate, immediately forming the legal entity and putting all the IP created in the company is paramount to not finding yourself in this situation.    

4. Spending too much time coming up with special vesting arrangements for co-founders

You are not only an incredibly intelligent individual but you are brave enough to put everything on the line to pursue an idea you feel passionate about. That fact is what gets me up in the morning to work and why I love my job so much. BUT, nothing is more frustrating that seeing you divert your efforts and intelligence away from building your company to instead coming up with novel vesting schedule schemes for you and your co-founders. 9 out of 10 times it will end up being a waste of the company’s money and time. Stick to what you do really well. Building companies. Not unique vesting schedules.

5. Not filing 83(b)s

And… I saved the best for last. You go through the incorporation process with your lawyers. You form your entity, you finalize equity documents and then you are off to the races building your company. You are feeling really good until you find out that your lawyer (and most likely their paralegal or junior associate) becomes complacent and fails to file or remind you to file your 83(b) election for the un-vested equity you received at incorporation. This is the ultimate mistake you and your lawyer can make out of the gate. If a founder does not make an 83(b) election, in any taxable year in which equity vests, the founder will be required to include in his/her gross income as ordinary income the delta between the fair market value of the equity at the time such equity vests and the price he/she paid for the equity.  As a result, income that likely would have been taxable at capital gain rates upon sale if the founder had made an 83(b) election would be taxable at ordinary income rates upon vesting. Yikes. 

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.