In the world of early stage investing, there exists a range of structures from the most founder friendly to the most investor friendly.
The most investor-friendly structure involves some type of a priced round in which the investor receives shares of a class of preferred stock with a negotiated set of enhanced economic, management and exit rights. These rights and other terms are memorialized in a group of governance documents and agreements among the company, the investors and the founders.
On the other hand, the most founder-friendly investment structure is the simple agreement for future equity, or SAFE, which is similar to a convertible note but notably lacks an interest component and a maturity date. Next along the range of investor friendliness is the convertible note, which contains several investor protections, including interest, maturity, some reps and warranties and (sometimes) security. In the real world, however, more sophisticated investors routinely augment their protection under both SAFEs and convertible notes by negotiating side letters that provide them with more enhanced rights.
Documentation for priced rounds and SAFEs have benefited from standardization. The National Venture Capital Association website open sources a set of standard Series A documents which are a convenient starting point for initial VC rounds. Ted Wang of Fenwick & West developed a set of standard Series Seed documents in 2010 for use in lower dollar amount priced rounds. Gust Launch, a SaaS platform for founding, operating and investing in startups open sources a slightly more elaborate set of Series Seed documents. And Y Combinator, which created the SAFE, open sources its several varieties of the SAFE on its website. Only convertible notes have lacked standardization and the efficiencies that come with it.
Recently, however, the Angel Capital Association published a convertible note (the “ACA Note”) and related term sheet which is intended to do for convertible notes what the NVCA did for venture rounds, what Ted Wang and Gust did for Series Seed deals and what Y Combinator did for SAFEs. Its mandate was “to create an enhanced model convertible promissory note that would combine common convertible promissory note provisions with ‘best practice’ provisions often found in side-letters…and [balance] the rights of founders and investors”.
The ACA Note has several key provisions that are not typically found in most early stage convertible notes but are often negotiated for in side letters by more sophisticated investors. These include:
- Expanded representations and warranties. The intention here is to include useful information that early stage investors want but which does not require significant time for a company to compile, but avoid reps and warranties that are more appropriate for later stage deals.
- Participation rights in future financings. Interestingly, participation rights are the only rights included in Y Combinator’s standard side letter for use with SAFEs.
- Select information rights. The information rights provision in the ACA Note includes unaudited annual and quarterly GAAP financials, progress updates, cap tables (upon request), information required by Section 4(a)(7) of the Securities Act (private resales of restricted securities), and inspection rights as provided under Section 220 of the Delaware General Corporation Law. Investors may consider also negotiating for a requirement that the company execute a management rights letter upon conversion of the note to ensure that investors continue to have access to company information after a conversion notwithstanding “major investor” ownership requirements.
- Most favored nation rights. MFN clauses in convertible notes protect the interest of investors and ensures that the terms of their convertible note will always be at least as favorable as those contained in any convertible notes subsequently issued by the company. For example, if the company agrees to a lower valuation cap or a higher discount rate with a subsequent investor, the first investor with the MFN clause will automatically receive those same terms.
- Board observer rights. The ACA Note includes observer rights with a board representation alternative. Board representation and/or observer rights are more common in larger convertible note rounds. Board representation rights should be coupled with a requirement for indemnification of directors and D&O insurance.
- Protective provisions. These are provisions requiring majority noteholder approval for select corporate acts while the notes are outstanding. Most convertible note rounds do not have protective provisions for the noteholders. The ACA Note seeks a balanced approach that limits the veto right to those matters that would otherwise directly adversely affect the noteholders but for which a veto would not result in extensive control of company affairs.
- IP agreements. This is a requirement that all employees and independent contractors whose services are related to the company’s IP sign confidentiality and proprietary information and inventions assignment agreements. This is an important aspect of due diligence in angel investment rounds that is often missed.
Despite the ACA’s stated objective of balancing the rights of founders and investors, the ACA Note does favor investors with the addition of certain pro-investor provisions as outlined above. Companies using the ACA Note will need to consider these investor enhancements carefully, for example the requirement to provide GAAP financials. Thankfully missing from the ACA Note, however, is a representation by the Company and the Investor (which is included in Y Combinator SAFEs) that neither one has modified the form, except to fill in blanks and bracketed terms, which means the ACA Note does leave open the possibility of some negotiation.
Nevertheless, the ACA Note could achieve for convertible notes what the NVCA documents have done for venture, Gust Launch for Series Seed and Y Combinator for SAFEs. The ACA Note could help set achievable expectations, encourage negotiation transparency, reduce confusion and cut expenses, all of which could boost early stage investment.
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