You have a strategic plan; You have an MVP; You have a Team; and You have an Investor!
Both you and the Investor believe in the potential of the Entity. What the exact “potential” is, however, still a matter under discussion.
You hope that the Entity will grow quickly and you will need to sell less equity for the cash you need to scale; the Investor wants to maximize its return – including being well compensated for investing early on and providing essential early-stage funding and support.
However, the truth is that you need money NOW!
What to do?
Two common alternatives are Convertible Promissory Notes (“Notes”) and SAFE Agreements (“SAFEs”). How these instruments work is often misunderstood by Entrepreneurs. So let’s look at some examples:
CONVERTIBLE PROMISSORY NOTES
Key Concepts: There are some concepts that are key to understanding a Note, including:
Principal Amount – the amount that the Investor invests in the Entity
Term – the timeframe in which the Entity has to either (i) convert the Note into equity, or (ii) repay the Principal and Interest outstanding on the Note
Interest Rate – the stated rate of interest paid by the Entity while the Note is outstanding. Usually, it is a simple rate of interest, but it can be compounded rate depending on the terms set for in the Note
Discount Rate – the per share discount that the Entrepreneur provides to the Investor to further reward the Investor for investing at such an early-stage. The Discount Rate is most often from 10% to 20%
Valuation Cap – an additional opportunity provided to the Investor for investing at such an early-stage which enhances the return that the Investor obtains if the Entity realizes or exceeds an agreed to value in connection with its first formal funding round
Qualified Funding – the equity transaction of a minimum amount, undertaken by the Entity during the Term Note, pursuant to which the Notes are automatically converted into that class of equity that the Entrepreneur is currently offering to other new investors – usually in the form of either Series A Preferred Stock or Series Seed Preferred Stock
Default and Remedies – the actions the Investor can then take to recover (or not) its investment in the event that the Note is not converted or repaid during the Term.
Example No.1 (No Discount or Valuation Cap): An Entity offers a Note which will be outstanding for two (2) year, in the principal amount of $750,000, with an Interest Rate of 6.0% per annum. The Investor agrees to invest $100,000. No Discount Rate is provided.
Under the terms of the Note, when the Entity sells at least $2,000,000 of Series A Preferred Stock, with a purchase price of $1.00 per share, the Note will AUTOMATICALLY convert into Series A Preferred Stock at $1.00 per share, and the Investor will receive 100,000 shares of Series A Preferred Stock.
Example No. 2 (Discount Rate). If, however, a Discount Rate had been negotiated, the calculation would be slightly different. In the above scenario, let’s assume that 20% Discount Rate had been agreed to. Accordingly, the Investor would have converted its Note at $.80 per share and received 125,000 shares of Series A Preferred Stock.
Example No. 3 (Valuation Cap) .In the above scenario, let’s assume that the Entity and the Investor also agree that there will be a $6,000,000 Valuation Cap. Evaluating for the moment just the economic effect of the Valuation Cap, the Valuation Cap is divided by the pre-money valuation, and the per share price that the Investor will purchase the Series A Preferred Stock is determined. In this case, the price per share is $0.75 per share. Hence, the Investor who originally invested $100,000, will now receive, in connection with a Qualified Funding of $2,000,000 shares of Series A Preferred Stock, 133,333 shares of Series A Preferred Stock as a result of there being a Valuation Cap or 8,333 additional shares of Series A Preferred Stock.
Entrepreneurs tend to resist the inclusion of Valuation Caps, for fear that, as above, Investors may receive a “windfall” when the Entity early-on exceeds expectations. However, Investors counter, often very effectively, that the Valuation Cap is really how an Investor is fully compensated for having had the foresight and risk tolerance that was essential not only to the Entity’s early survival, but also to its accelerated commercialization.
Entrepreneurs should understand that while both a Valuation Cap and a Discount Rate are detailed in a Convertible Note, Investors will calculate method provides the lowest per share price at which the Convertible Note is converted into shares of Series A Preferred Stock – which gives the Investor the greatest number of shares of Series A Preferred Stock, and will then maximize returns.
Entrepreneurs should also be aware that Valuation Caps are not really “caps” – they don’t limit the shares that investors receive. Moreover, even when discussed and agreed to, a Valuation Cap is not a fair market appraisal of the true “value” of the Entity and, indeed, the value attributed to the Entity at the first priced round of funding may be, and all too often is, lower.
Default and Remedies: In the event that an Entity never undertakes a Qualified Funding, once the Maturity Date arrives, the Entity and the Investor will need to come to terms with how they will move forward. Some Notes allow Investors to declare that the Convertible Note is in default and file suit against the Entity for breach and obtain repayment—an expensive and often fruitless course of action as it is likely that the Entity does not have the ability to repay the Investor. Some Notes allow the Investor to convert its investment into whatever the most senior securities of the Entity that is then outstanding, transforming its position into that of a pure equity holders. Some Notes are silent as to what happens if a Note is not repaid or converted on or before the Maturity Date which often leads to unpleasant and unsatisfactory conversations between investors and entrepreneurs, in part, to the vagaries of the situation and unrealized expectations.
Other Rights: When an Investor is investing not only to realize a financial return, but also (and maybe more importantly) for purposes of furthering a strategic relationship, such Investor may ask “Super Rights” –rights that are above and beyond anything being provided to other holders of the Notes.
One example of such “Super Rights” is for an Investor to be entitled to observe and participate in board meetings (“Observation Rights”). Another example of a Super Right is for the Investor to be entitled to purchase a certain percentage of each new series of equity offered by the Entity in the future—not just in the Series A offering, but in every round of funding that the Entity conducts thereafter—thus giving the Investor the opportunity to maintain its equity ownership in the Entity and to assure themselves a continuing role and influence over important decisions.
“SAFE” NOTES/SAFE AGREEMENTS/SAFES
Safe Agreements (sometimes referred to as “SAFE Notes, but they really are not “Notes”) – are, in their most basic form, an arrangement whereby an Investor provides the Principal Amount to the Entity, in return for the right to convert the SAFE into whatever equity is then being issued by the Entity, often at a Discounted Rate or subject to a Valuation Cap, or both, when a Qualified Financing occurs.
SAFES don’t contain Maturity Dates; SAFES rarely contain Defaults or Remedies – which means that for Investors, in the event that a Qualified Financing, liquidity event or other terminating occurrence does not happen, the parties are left with some significant ambiguities.
SAFES do, however, frequently contain “Most Favored Nations” clauses whereby if the Entity offers, for example, Super Rights to another investor, then all SAFE holders are entitled to those same Super Rights. However, while SAFES are often viewed positively by entrepreneurs, they can also be a narcotic – simply and quickly used to provided needed cash for the Entity, they allow entrepreneurs to avoid seriously considering the amount of equity that is, in fact, being sold. Hence, for example, an entrepreneur who raises $2,000,000 in SAFES, and then receives a $4,000,000 pre-money valuation at the first formal round of funding, may be surprised to discover at closing that it has already sold as much as 33% equity stake in the Entity to the holders of the SAFES. When this is added to the equity that is sold to new Investors, entrepreneurs may be surprised how diluted their equity position has become
InsurTech Entrepreneurs: It is increasingly common for promising InsurTech companies to not only issue Notes or to enter into SAFES, but also to enter into commercial contracts with early Investors who are insurance companies. The duality of the relationship of both “Investor” and “customer” creates certain challenges, but is most often critical to the success of the Entity involved in the Insurance industry. Indeed, InsurTech companies often find themselves involved with both Investors that seek only financial returns as well as Investors that provide important strategic support as evidenced by commercial agreements. This disparity of alignment can be challenging. So early on, transparency is critical for the success of the relationship between an Insurtech Entity and its Investors.
For additional thoughts on Convertible Notes and SAFES, please see https://techcrunch.com/2017/07/08/why-safe-notes-are-not-safe-for-entrepreneurs/.