US Corporate Law 20 Episodes (8)

Convertible notes at angel investment stage, SAFE and KISS

What do the documents like convertible note, SAFE and KISS mean? What documents are often used in angel investment and venture capital? What does Equity Financing vs Debt Financing/ Qualified Financing/ Discount/ Cap/ Most Favored Nations mean?

In the previous lecture, we introduced the difference between angel investment, venture capital and private equity investment. Well, in this issue, let's talk about the legal documents commonly used in angel rounds.

To put it simply, the common ones are convertible note, SAFE, KISS. In Chinese, they are convertible bonds, simple agreements for future investments, and simple securities. Of course, the latter two are the abbreviations of a string of English words, so everyone basically uses the English abbreviation to call them, and they are not very good at translating them into Chinese, and the first convertible bonds are often called directly in Chinese.

First of all, let's be clear. As we said in the last issue, the names of angel rounds and seed rounds are often not so clear-cut. In the investment world, you may hear some people say that these are angel round documents, and others say This is the file for the seed round. But in American law firms, when lawyers say seed round, they mean a very formal seed round preferred stock purchase agreement and a complete set of more than a dozen documents. The angel wheel that the lawyer refers to is often the above three documents.

1. Convertible notes

Let’s talk about convertible bonds first, which is also what everyone hears most often. As the name suggests, it is a convertible debt, specifically a debt that can be converted into shares. Ultimately the concept ends up on debt, so it's a debt, not a share.

The core terms of convertible bonds are that the investor first lends you $100,000, for example, and then sets a time point (called maturity date, usually 18 months), if the company has already raised to the next round before this Formal financing has been completed, and angel investors often agree on an amount for the next round of investment. For example, if you want to reach $2 million in the next round, this is called Qualified Financing. If you meet this standard, then the angel investor’s The money will follow the next round of formal investment and enter the next round. And if the company has not raised the next round of formal financing after 18 months, then the investors have the right to recover these debts, and often with interest (interest is generally 8%), and because angel investors enter the market Earlier, startups often gave investors a discount, ranging from 5% to 30%, but the most common one was 20%.

Originally, if investors want to invest money, it is not enough to directly invest in the company. Why does it appear in such a form? Apart from the fact that the lawyers of convertible bonds are relatively low, there are mainly two reasons.

The first is that if you want to do a formal round of financing, then you need to determine the valuation of the company. With the valuation, you can know how much the investor has invested in the company's share of 100,000. However, it is difficult for the company to make a valuation of the company in the very early stage, and the investors of the angel round are often individuals or small institutions, and they do not have the ability to evaluate the specific valuation of a startup company, so the investors of the angel round are often individuals or small institutions. This work is often pushed to the next round of formal investors to do it, and it is a free ride for myself.

The second is that because the company is too small and the prospects are uncertain, the way of debt is used to give investors more protection and freedom.

2. Simple Agreement for Future Equity (SAFE-Simple Agreement for Future Equity)

You will find that the official seed round is a kind of equity financing, and the convertible bond is a kind of debt financing. Equity and bonds are also the two main ways of financing. In fact, these two methods have already covered the needs of early investors, but as entrepreneurship becomes more active, transactions become more and more frequent. Those who do not want to choose convertible bonds can only use formal seed round financing, spending a lot of time and money to negotiate the specific terms in each document, which is very unfavorable to effectively promote the investment process. So, in 2013, Y Combinator, commonly referred to as YC, they invented another simple and easy-to-implement model document, which is SAFE-Simple Agreement for Future Equity, which is called in Chinese, a simple agreement for future investment.

SAFE is an equity investment, but a bond investment with an uncertain price.

The core clause of SAFE is that the angel investors give you a sum of money without interest. No matter when you get the next round of financing, the money given to you by the angel investors at the beginning will be unconditionally converted into the next round of financing. Stocks have no right to be withdrawn.

In addition, YC has thoughtfully designed four different types of SAFE. In the United States, you often hear lawyers say that SAFE comes in 4 different flavors.

(1). Capped, no discount

(2). No limit, discount

(3). Capped, discounted

(4). No cap, no discount, but MFN treatment

In fact, these four types are the permutation and combination of the two terms "cap" and "discount", plus a most-favored-nation treatment.

The so-called "cap" is the maximum amount that a startup's next round of valuation is required to exceed. You may find it strange that investors don’t all hope that the higher the valuation of startups, the better? This shows that the company they are investing in has value. But think about it, if investors are willing to give money to a startup company unconditionally, without repayment or interest, then this company is often very popular, and many investors are not allowed to throw money into it. So naturally the next round of financing is just around the corner. In this case, the angel investors are not worried that the company is worthless at all, but worry that the startup company will be too valuable in the next round, so the 100,000,200,000 shares invested by the angel investors at the beginning are too small.

The so-called "discount" is similar to that of convertible bonds. After all, it is an early investor who can give some appropriate discounts. The discount range is also 5%-30%, but the most common one is 20%.

The so-called "most-favored-nation treatment" means "refund the price difference if you buy more expensively". If I am an angel investor and I come first, the condition you give me is a 10% discount, but the investor who comes in later than me With a 20% discount, then as an earlier angel investor, I can ask the startup to give me the same 20% discount.

This sounds like a good deal because for a startup, there are no 18 months stuck and no interest. But for angel investors, the problem is that if the company never raises the next round and never fails, what exactly is the money?

In response to this problem, investment documents such as KISS appeared later.

3. KISS-Keep it Simple Security

KISS is another incubator called 500 Startups invented in 2014. Its existence effectively fills the gap between convertible note and SAFE.

There are two types of KISS, one is equity type and the other is debt type. In fact, its equity type is very similar to SAFE, and its debt type is very similar to convertible note.

The difference is that KISS has added a lot of details and terms, and it looks more like a formal round of financing. But this is also the reason why KISS is not used too much in practice, because it adds too much trouble to make up for the loopholes of convertible note and SAFE, but it still can't get rid of the shell of convertible note and SAFE.

In our usual angel round financing, SAFE is now more and more used, followed by convertible note, and the usage rate of KISS is less than 5%. So we won't start talking about KISS here today.

Today, I introduced the common legal documents for angel round financing. In the next lecture, we will talk about the legal documents commonly used in the formal venture capital A, B, and C rounds, and will start from the first Term Sheet that the entrepreneur gets.

See you in the next issue.