Category Archives: Negotiation Tips

Convertible Note SAFE

Convertible Note and SAFE Overview

Startups commonly raise money through one of two instruments: (1) Convertible Note; or (2) SAFE (Simple Agreement for Future Equity).  While these instruments are common, founders need to understand the basics of each instrument and the points of negotiation available.  This overview is part 1 of a 4 part series that, in future instalments, will cover negotiating each type of instrument and consider an alternative to these instruments.

Why use a Convertible Note or SAFE?

The Convertible Note and SAFE allow a startup to raise money without determining a value for the company.  Many early-stage companies do not or cannot determine a company valuation, especially those companies that are pre-launch, yet need to raise money.  These instruments are used to raise money but kick the question of valuation down the road until a future round values the company, otherwise known as a “priced round”.  Among startups, a priced round typically occurs with a Series-A financing, which involves issuing preferred shares to investors.

It’s important to understand that, under either instrument, equity is not initially issued to investors.  Instead, the instrument converts in the future into equity once the company raises a priced round, thereby establishing a company valuation at which the instrument can be converted.

NOTE – It is possible for startups to raise in priced rounds from day 1, a topic I will discuss in the final part of this series.

What is the difference between a Convertible Note and a SAFE?

A Convertible Note is a debt-equity instrument and, accordingly, charges interest while a SAFE is an equity instrument.  The interest element to the Convertible Note was part of the reason for the shift to SAFEs as this element created, in some situations, unnecessary legal issues.

From a negotiation standpoint, the instruments vary in the different elements commonly subject to negotiation.  A Convertible Note involves, at a minimum, discussions around: cap, discount, interest and maturity date .  Conversely, a SAFE usually involves one point of negotiation: cap.  This single point of negotiation has led to increased use of the SAFE over the Convertible Note.

These instruments also differ in how they convert.  A SAFE only converts upon a preferred share financing round (a priced round), which usually is a Series-A financing.  If a preferred share round does not occur then the SAFE remains unconverted and no shares are issued to the SAFE holder.  Conversely, a Convertible Note converts upon either a priced round (may not be preferred, depends on the note) OR at its maturity date.  As a result, a Convertible Note will always convert while a SAFE may not.

NOTE – there are additional points that can be negotiated on both Convertible Notes and SAFEs, for example, a discount or preemptive rights.

What is a Cap, Discount, Interest and Maturity Date?

Cap:  the maximum value at which the instrument converts into equity.  If the priced round values the company below the cap, the instrument converts at the priced round value (perhaps with a discount) and if the priced round values the company greater than the cap, the instrument converts at the cap value.  For example, if a company raises a priced round valuing the company at $12 million and a SAFE has a $10 million cap, the SAFE converts at a $10 million valuation.  It is possible for Convertible Notes and SAFEs to be issued without a cap, meaning that they convert at the priced round valuation, perhaps with a discount.

Discount:  discount an investor receives on conversion of the instrument, which may only occur upon particular conversion scenarios.

Interest:  Convertible Notes have a debt element and, accordingly, charge interest to the company issuing the note.  Interest is calculated into the total value of the Convertible Note upon conversion.

Maturity Date:  the date on which a Convertible Note must have converted by and, if no conversion has occurred, the note automatically converts on the maturity date.

Overall, Convertible Notes and SAFES are similar in the goal each instrument tries to achieve: raising money without determining a company valuation.  While similar in goal, each document has its own negotiation points, which will be covered in our next blog posts.  Stay tuned!

Fully-Diluted Calculations

Congratulations, you received a term sheet!  While the main terms, such as valuation, are certainly important, there are numerous less noticeable terms that can have just as great an impact.  One such term is “fully-diluted”.

What is a fully-diluted calculation?

A fully-diluted calculation assumes that all options, warrants and other rights to acquire stock have been exercised or converted, regardless of whether they are actually vested or exercisable at the time of the offering.

Let’s illustrate the impact of a fully-diluted calculation compared to a funding round without full dilution.

Startup has issued 1,000,000 shares and 100,000 options.  None of the options are vested.  Investor desires to take 10% interest in the company.

Not fully-diluted:  Startup will use the number of issued shares only to calculate the 10%  and will issue investor 111,100 shares (representing 10%).

Fully-diluted:  Startup will use the total number of issued shares and options to calculate the 10% and issue the investor 122,200 shares.  However, since none of the options are vested, and may never vest, investor actually acquired a present-day interest of 10.89%.

While the above example seems benign given the .89% difference, that percentage could be worth a large sum if the company exits in the future.  What if you are selling an almost controlling interest in the company, perhaps 23.5%?  In that case, a fully-diluted calculation could result in a sale of a 25%+ (and controlling) present-day interest depending on the number of outstanding options etc.  In other situations, an investor may request that the entire option pool (even if no options have been granted) be factored into the fully-diluted calculation – in the case of a 12% option pool, this term would have a substantial impact.

In sum: while you may not be able to avoid a fully-diluted calculation in a term sheet, it’s important to understand its impact and to negotiate with that impact in mind.

My Problem with the NDA

I’m against the NDA.  This is common sentiment in the technology sector as well.  Before I dive into my issues with the NDA, let’s distinguish between types of NDA.

A Non-Disclosure Agreement is an agreement that requires a receiving party to not disclose or use certain information that the disclosing party wants to provide. Typically they are provided as a start to business negotiations or as part of a broader agreement.

I don’t take issue with NDAs that protect business information, such as financials, business plans or product launch plans or NDAs that are part of a broader agreement.

I do take issue with stand-alone NDAs that serve only to protect the “next great idea”. An idea (excluding patentable ideas) has no value; execution of an idea has value. Indeed, the same idea can be executed multiple ways with only a single approach achieving success.

Signing an NDA protecting an idea has the potential to limit your company’s own product development in the future as you will be restricted from “directly or indirectly” using the idea. Who is to say that you would not have arrived at the idea yourself, which is especially common in industries where most ideas are slight derivatives of what’s already out there, or what “indirect” use of an idea means. Further, imagine the challenge of creating a company-wide “ideas bank” where you place all ideas presented in NDAs and that you can never use.

A smart company will not use an NDA and, instead, will intelligently disclose the bare minimum level of information necessary for discussions to continue. These smart companies recognize that NDAs are hard to enforce as you face the burden of discovering an alleged breach and establishing that the breach actually involves information protected by the NDA. They also realize that NDAs tend to slow business negotiations.

Instead of the NDA, control what you say.  It’s far is far easier than trying to control what other people have already been told.

Game or App Ripped Off? Here’s what to do:

Whenever a developer discovers a copied version of their app/game, their immediate concern is how to remove it.  This post aims to outline the process for removing content that infringes your copyright from major app/game stores.

All major stores operated by U.S. companies (and often foreign companies) comply with the United States Digital Millennium Copyright Act (“DMCA”).  Simply summarized, the DMCA provides a notice-and-takedown procedure whereby a notice of copyright infringement sent to a DMCA Agent leads to the take down of infringing content.

STEP 1.  DMCA Notification

The DMCA Agent should be your primary contact as the DMCA specifies a procedure for copyright infringement claims and major stores will follow the procedure.  Here are links to the DMCA Agent for each major store:

Steam:  https://steamcommunity.com/dmca/create/

Apple:  http://www.apple.com/legal/internet-services/itunes/appstorenotices/

Google Android:  https://support.google.com/legal/troubleshooter/1114905?product=androidmarket

Facebook:  https://www.facebook.com/help/contact/208282075858952

Microsoft:  https://www.microsoft.com/info/cpyrtInfrg.aspx 

You must complete and send the notice of copyright infringement contained in these forms to the DMCA Agent in order to initiate the DMCA process.  After you send notice, the DMCA Agent should remove, or disable access to, the allegedly infringing app/game and send notification of such removal to the infringer.

DMCA Agent response time varies.  Indeed, U.S. courts are currently determining what period of time constitutes a reasonable response!

STEP 2.  Utilizing Connections and Social Media

After sending the notification, feel free to contact anyone you know at the app/game store or use Twitter and other social media to push your cause.  Often a campaign will cause a quick response from the DMCA Agent.

STEP 3.  Cease and Desist

Consider sending a cease and desist letter to the infringer as well, requesting that they remove the infringing content from the store (perhaps also request sales proceeds).  Where the store or website does not comply with the DMCA, this may be the first or second step.

STEP 4.  DMCA Counter Notification and Lawsuits

The infringer may respond with a counter notification claiming that the allegedly infringing content was removed as a result of mistake or misidentification.  The DMCA Agent, upon receiving counter notification, will let you know about the counter notification and will put the  content back on the store in 10-14 business days, unless  (before the content returns) you seek a restraining order against the alleged infringer and inform the DMCA Agent of the order.

In reality, the DMCA Agent likely will not receive a counter notification in the case of a blatant ripoff of your app/game.  Nonetheless, it’s important to know the steps that follow DMCA notification.