Category Archives: Startup Investment

SAFEs and the BC EBC Tax Credit

SAFEs (Simple Agreement for Future Equity) are used by early stage companies to raise investment without requiring the parties to determine the company’s value.  Instead, future events determine the company’s value and prompt conversion of the SAFE into equity.  As of March 2, 2019, SAFEs are now eligible for the British Columbia Eligible Business Corporation (EBC) tax credit, subject to certain requirements being met.

The EBC tax credit, in simple terms, is a 30% BC government tax credit received by investors for investments made in small businesses operating in qualifying industries in BC.  In order for an investor to receive the tax credit: the company must be operating in a qualifying industry; registered for the EBC credit; the investment structure must qualify; and funds must be allotted and available to the company for issuance of the credit.  Industries qualifying for the credit are quite broad and include: manufacturing; research and development of new technologies; destination tourism; digital media products; clean tech and advanced commercialization.  BC also offers a similar tax credit for Venture Capital Corporations, which operates under the same overall program.

SAFEs typically contain clauses rendering them ineligible for the EBC tax credit and the BC government did not originally allow SAFEs to be used in tandem with the EBC tax credit.  This posed a significant problem for small business that raised money with SAFEs.

While SAFEs are now eligible for the EBC tax credit, they need to be altered to remove clauses that make them ineligible.  While the alterations required depend largely where the SAFE documents originate, be it from Y Combinator or a SAFE drafted by a Canadian law firm, clauses that need to be removed include:

  • fixed term lengths of less than 5 years (admitted, more of a Convertible Note clause);
  • repayment prior to 5 years from the date of investment;
  • interest features (eligible SAFEs cannot operate as loans, again, more of a Convertible Note clause);
  • assignment clauses (except in very limited circumstances); and
  • liquidity and dissolution clauses that either allow for certain priority or preference over shareholders.

There are two ways to fix these issues:

  • redraft the SAFE to make it compliant; or
  • have each SAFE investor waive in perpetuity all rights that would make the SAFE ineligible.  

The first approach is preferable as a wavier may cause unforeseen problems if the SAFE is not drafted with a wavier in mind and may inadvertently cause an investor to forgo important negotiated terms. 

Nearly all of the SAFEs we review are ineligible for the EBC tax credit so investors should be wary if a company claims that their SAFE is EBC eligible.  Furthermore, as EBC program funds can run out every year, we recommend planning ahead and making sure that all your documents are in order so the tax credit is not missed out on.

Things Every Startup Should Know Before its First Financing

Startups often email me to assist with a financing expected to close a few days later.  Eager to get the deal going, I ask about deal structure, such as type of investment, investor rights and size of round, only to learn that structure has yet to be determined and no firm commitments have been made by investors.  While there is nothing wrong with these details being TBD, it benefits startups, their investors and legal counsel to fix as many deal terms before expectations of closing take root as until the above is set in stone, there is not deal.

Before beginning your first fundraising round, consider the following:

  1.  Know your structure.  Fixing the structure for your investment round is critical and shows investors that the company is sophisticated.  Options include a priced round, convertible notes and SAFEs.  There’s nothing worse than pitching to an interested investor and being unable to answer questions about the round’s structure.
  2. Have your Documents Ready.  Be ready to close your lead investor quickly if they are ready to move forward with the investment.  While investment documents may be negotiated further, having the documents ready shows professionalism and speeds the transaction toward close.
  3. Don’t treat Interest as Commitment.  Until investors move beyond expressing interest and into reviewing and negotiating deal documents there is little merit to their interest.  In my experience, converting investor interest into investor commitment is much more challenging than expected and you don’t want to plan the company’s direction over the next year based off expressed interest only to find out that you can close 1/2 the amount expected.
  4. Be Realistic in Closing Timeline.  Attempting to close a round in a few days only happens if the above points have been addressed by the company.  Legal counsel can prepare documents as quickly as the client requires but investors won’t move quickly until they know the investment structure and previously received draft documentation.  With this in mind, set a realistic closing timeline.

Closing your first financing is daunting.  By keeping in mind structure, documentation, investor commitments and setting realistic closing time-frames you will put your startup in a better position to successfully close the round.

Priced Rounds

As part of our day-to-day practice, we advise clients on different structures available for early-stage financing rounds.  As part of these discussions, convertible notes and SAFEs are inevitably raised by the founder yet the concept of a priced round is rarely raised and sometimes not even understood by the founder.  Priced rounds were the common approach to financing startups at all stages for over 25 years and are slowly making a comeback, which should be to the benefit of founders.

Understanding the Priced Round.  Priced rounds are simple:  the company and investors agree to a company valuation and the investors purchase shares in the company at this valuation.  Conversely, convertible notes and SAFEs are premised on the parties NOT agreeing to a company valuation, which is answered at a later date when a priced round occurs (typically the series A round) and the convertible notes or SAFEs convert.

When are Rounds Priced?  These days, priced rounds first arise during the Series A financing, where preferred shares are sold to investors.  At this stage convertible notes and SAFEs usually convert.  However, as advocated for in this post, any round can be priced including angel and seed rounds.

What are the Benefits to a Priced Round?  The company knows exactly what % of the company is being sold in the round and the founders know exactly how much they are diluted.  In a convertible note or SAFE financing there is some uncertainty as to how much of the company is actually being sold as these instruments typically convert on a fully diluted basis including the increase in option pool size required by the Series A investors yet the increase in the option pool is unknown until the Series A round.  Additionally, priced rounds eliminate the confusion surrounding how numerous convertible notes and SAFEs, with different caps and conversion terms, convert (these calculations are difficult to understand, even for sophisticated parties).

We encourage our clients to explore priced common share rounds when considering the structure for their next early-stage investment round.   Admittedly, some investors prefer convertible notes and SAFEs and others will reject a priced round valuation but accept the same valuation (or higher) as the cap on a convertible note or SAFE.  While priced rounds may not work in all situations there is no harm in floating this as a possible investment structure.  Indeed, sophisticated VCs, such as Fred Wilson of Union Square Ventures, agree that pricing rounds may be in the best interest of startups and their founders and should be explored rather than avoided.

Avoid Absolute Anti-Dilution Protection

Anti-dilution protections are frequently granted to investors and forgotten by founders until their friendly lawyer brings it up.  In many cases, anti-dilution protections are reasonable but in other cases can impose a substantial burden on the company, even impacting the appeal of the company to future investors.

Generally, anti-dilution protections protect an investor from the dilution of the investor’s interest.  When VC’s speak about anti-dilution they are usually referring to price-based anti-dilution protections, which protect from a decrease in share price in a future financing (known as a “down-round”) by, ultimately, increasing the number of shares issued to previous round investors.  This down-round protection is seen in Series A financings and Brad Feld has a great post covering the details.

What is FAR less common, and almost universally viewed as inappropriate, is an absolute anti-dilution clause.  This type of dilution protection guarantees the investor a certain percentage of the company, usually for a fixed time.  For example:

Startup hereby agrees to issue additional shares of Common Stock (for no additional consideration) to maintain Investor’s ownership interest at 10% of the total capital stock (calculated on a fully-diluted basis, including all options, warrants, convertible securities and other rights to acquire capital stock).

In the above case, the investor maintains a 10% interest in the company without a need to make additional payments.  What if the company sells shares to a new investor?  New shares are issued to the previous investor.  What if the company issues options to employees?  New shares are issued to the previous investor.  The absolute anti-dilution clause is viewed as inappropriate as it protects the investor against ALL dilutive events, including those every investor expects to occur, rather than a limited set of dilutive events, such as a down-round.

The absolute anti-dilution clause also runs the risk of rendering your company less appealing to investors.  An investor may reconsider an investment knowing that they will be immediately diluted by the previous investor’s absolute anti-dilution clause.  This is especially the case if the new investor is increasing the company share price and, in turn, the value of the previous investor’s shares.

I usually encounter these absolute anti-dilution clauses in connection with an accelerator program investment.  In this scenario, clients tend to accept the terms as acceptance to the program is viewed as worth the cost (which is a reasonable position to take).  Nonetheless, it’s important for companies to understand the impact of absolute anti-dilution clauses and to weigh the pros and cons of any investment in light of an absolute anti-dilution clause before proceeding further.