Tag Archives: startup law

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!

Investors don’t care where your Startup is Incorporated

Many founders I speak with are concerned about where their startup is incorporated and how this could impact fundraising opportunities in the United States.  In reality, this concern is unfounded.

Any sophisticated investor considers the product/service, team, market potential and other commercialization factors before, if at all, considering where a startup is incorporated.  In some circumstances, an investor may request that the startup alter its jurisdiction of incorporation but whether or not they proceed with the investment is determined 90% by quality of the company over jurisdiction of incorporation.  As relayed to me by Canadian founders, “if an investor passes because you’re a Canadian company, that’s not the real reason for passing“.

Where an investor requires your startup to be incorporated in the U.S. there is a simple process for creating this structure that I discussed in a previous blog post – The Canadian-U.S. Swap: Moving an Early-Stage Startup to the U.S.

Canadian founders should focus on building a compelling product/service and not waste energy worrying about minutia of incorporation.  Sell investors on your company and any issues concerning where your company is incorporated can be worked out between your legal counsel and investors.

Startup Employment Agreements

Working with early-stage startups and game studios, we are often involved in key company decisions, such as a first hire.  Lately, with many of our clients growing their teams, we’ve been fielding questions concerning the scope of employment agreements.  Below are a few recommendations:

  1.  Consider a less strict intellectual property ownership clause.  From the outset, I must stress that the company needs to own employee work product.  However, there are different ways to define what constitutes “work product”.  The most contentious IP clauses grant the company ownership of everything created during employment, at home or at work.  These broad clauses are often at odds with the creative nature of the industry, where employees work on personal projects outside the office, which do not relate to the employer’s business.  For example, making indie games outside of working at a AAA studio.  Further, such broad clauses can drive away prospective employees.  While each company’s needs are different, a carefully crafted IP clause can ensure company ownership of work product while encouraging employee creativity in a manner that does not jeopardize such ownership.
  2. Non-compete clauses are useless (in many jurisdictions).  There seems to be an infatuation with non-compete clauses among early-stage founders, perhaps because there is a presumption that the clause will protect the company’s interests.  It won’t.  In many states (California, for example) non-compete clauses are unenforceable against employees (excluding senior management).   If you’re asking a junior dev. to sign a non-compete, it’s probably unenforceable.  If non-competes are enforceable in your jurisdiction, the clause must be carefully crafted – as a broad clause will be found unenforceable.   In my opinion, I always exclude non-compete clauses unless there is truly a reason for the clause and I believe there is a reasonable chance it will be enforceable.  In most cases, a standard confidentiality clause will provide the company sufficient protection.
  3. Law overrides employment terms.  Employees may be entitled to overtime, paid vacation etc., the terms of which are set by the laws of your jurisdiction.  As a result you, can’t force an employee to waive the rights to which they are legally entitled.  For example, an employee agreeing to be paid a flat wage when the employee is also entitled to overtime is not legal.  When hiring an employee, be sure that the employment terms are consistent with applicable laws.  When you start introducing startup employment trends (unlimited paid vacation, for example), further caution is needed to ensure that the trend reconciles with the legal requirements of your jurisdiction.  Tip:  speak with your legal counsel.

In addition to the above considerations, we recommend that you have your lawyer draft an employment agreement template that reflects your legal needs.  In doing so, you can address the above concerns and create an agreement that will serve your company needs as the team begins to grow.

Revisiting “Should I Incorporate my Canadian Startup in Delaware?”

It seems Canadians are still wrestling with whether to incorporate their startup in Delaware.  I wrote about this question back in September 2014  and since then the post has racked up over 1,000 views.  Back then, I concluded with this piece of advice, which I still stand by:

Don’t lock yourself into Delaware before you know where your investment comes from.  Based upon the cost and complexity of operating a Delaware startup from Canada, I recommend that you incorporate in Canada at the start.  Where a future U.S. investor requires you to incorporate in Delaware (or another state) your legal advisors can assist with this transition.  Conversely, Canadian investors may prefer to invest in a Canadian company!

Tip:  your product/service is important, not the place of incorporation.