Friday, August 22, 2014

New Seed Financing Documents (500 Startups and Y Combinator)

The startup industry keeps on coming up with new innovative solutions to seed financing.  The latest trend is convertible equity.  Two startup venture funds and incubators, 500 Startups and Y Combinator, recently released their versions of convertible equity documents.


In 2013, Y Combinator, a well-known seed incubator and venture fund, released its own version of equity securities that it refers to as SAFE (simple agreement for future equity).

Benefits of SAFE

SAFE securities are not convertible notes because they don't have the common features of debt instruments: maturity and interest rate.  This means that there is no debt on the startup's balance sheet.  Since this investment does not mature, it removes the risk of startup insolvency in the case of non-repayment and non-conversion into equity.  Terms are simple, with valuation cap being the only negotiated item.  By investing in a SAFE security, the investor gives money to the startup in exchange for a promise to receive preferred stock in the event of future equity financing.  There is no deadline and there is typically no minimum size of equity financing.  SAFE securities terminate either at IPO or change of control or conversion into equity.

Different Types of SAFE Securities

There are essentially four types of SAFE securities proposed by Y Combinator.

1.  SAFE with a cap and a discount.
2.  SAFE with a discount, but no cap.
3.  SAFE with a cap, but no discount.
4.  SAFE without a cap or a discount, but with an MFN provision, which says that if the company were to issue another SAFE with more favorable terms, this SAFE documents will be amended to benefit from similar terms.  However, there is no automatic conversion into equity unless the amount of equity financing is at least $250,000.

SAFE securities are designed to protect the investor in the case if the startup valuation decreases in time for that equity financing.  So, if the SAFE valuation happens to be higher than the valuation at the time of a priced equity round, then SAFE converts into the preferred stock at the same lower valuation of the preferred stock.  If the SAFE valuation is lower than the valuation of the company right before the equity financing, then the holder of SAFE securities gets shares of preferred stock calculated using its own valuation cap, not the higher valuation of the equity financing.  Then, SAFE securities convert into a Series SAFE preferred (also referred to as "shadow preferred" or "sub-series preferred", which has the same features as the preferred stock that the company is issuing except for the conversion price, liquidation preference (which still equals to the original investment amount into SAFE securities) and dividend rate.  In the event of the company sale, the SAFE security holders get a choice of either converting its securities into shares of common stock based on its valuation cap, or having the investment returned.


However, investors may still feel weary of using SAFE equity or other convertible equity structures because they are too favorable to the companies.  There is just too little protection for the investors in the event that the company fails to raise any equity financing.  There is no maturity and no interest rate, so it is not possible for the investors to declare default.


On July 3, 2014, a well-known business incubator and fund 500 Startups released its own deal documents named KISS (keep it simple security) for convertible debt and convertible equity financings developed in collaboration with Gunderson Dettmer.

KISS Convertible Debt

I personally like their convertible note document.  It is clear and simple, and has no surprising terms.  Its maturity is 18 months, and the notes accrue interest at 5% that can be paid by the Company in cash.  It provides for an automatic conversion to preferred stock if the company raises a qualifying priced round ($1 million).  Conversion occurs at the lesser of a cap and a discount.  At a change of control event, investors have an option of either cashing out at a multiple of 2X or converting into common stock at the cap.  I particularly like that the KISS convertible note agreement addresses what happens at maturity in case of non-payment.  It provides for an option to convert into a newly created series seed shares using model documentation or explore other options (for example, extension of maturity).  This is not mandatory and is decided by the majority of note holders.  All KISS investors receive an MFN treatment and major investors (those who invested more than $50,000) receive basic information and participation rights.  

KISS Convertible Equity

KISS Equity securities have no interest rate (company-friendly feature) BUT have a maturity date of 18 months.  Just like the KISS convertible notes, they automatically convert into equity at the next round of equity financing but only if the financing is for $1 million or more (unlike SAFE securities that do not have a minimum financing amount unless this is SAFE with the MFN clause).  KISS Equity securities have both the discount and the valuation cap, and convert at the lesser of the two.  SAFE, on the other hand, has options in terms of how to structure the security (cap and discount or either cap or discount or none of the above but with an MFN treatment).  Treatment of KISS Equity in the case of a change in control or at maturity is the same as KISS Debt.  Like with convertible debt, the convertible equity securities offer the same MFN protection and major investors receive additional information and participation rights.  The convertible equity securities are treated on pari passu with other KISS securities and convertible debt securities, including in terms of repayment.

So, as far as I can see, the main difference between KISS Equity and KISS Debt is that KISS Equity securities do not have an interest rate.  Is it sufficient to treat these securities as "equity"?


In conclusion, I would like to thank 500 Startups for developing a solid convertible debt purchase agreement.  I would definitely resort to it in the future. However, as of now, I am unlikely to recommend to my clients to use convertible equity structures, although it is good to know that this option exists.

This article is not a legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author, Arina Shulga.  Ms. Shulga is the founder of Shulga Law Firm, P.C., a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of business, corporate, securities, and intellectual property law.

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