This is a fictitious narrative without numbers and formulae between an investor and an early-stage startup founder. It discusses basic concepts of convertible notes, simple agreement for future equity (SAFE) and keep it simple security (KISS).
The real-world conversations are a lot more nuanced and include complexities for events such as early exits. Often, the negotiations might borrow concepts from more than one of these instruments to create a hybrid agreement. However, if you are looking for an introduction to these concepts, this might provide you a starting point. This article is for informational purposes only and is not legal, financial, accounting, or tax advice.
Convertible Notes
Investor: We love what you are doing and want to invest. What's your current valuation?
Founder: Honestly, it's too early to tell. We have a concept and a working model. Any guesstimates will be based on a long list of assumptions. Buyer's beware, that number will have a high margin of error.
Investor: Hmm, how do I know how much stake I am buying without a fair valuation. How about I give you a loan instead?
Founder: A loan? You got to be kidding. We have no revenue. We won't be able to pay you back anytime soon. The interest rate would cripple us.
Investor: You don't have to pay me back in cash. I will roll up the interest and add it to the amount of the loan. When you raise your first equity round, convert my loan into equity.
Founder: I can do that. That sounds straightforward. But what's in it for you?
Investor: Yeah, about that. When the conversion happens, I want to be able to buy the equity at a discounted rate.
Founder: That sounds fair.
Investor: There's one more thing I would like you to do for me. If you do an amazing job at this, which I feel you will, your company's valuation can be off the roof by the time you raise a round. That's great for you, but my converted debt might end up being a tiny stake.
Founder: That would be an outcome I would push for. I mean, not to reduce your stake, but to seek for the most valuation possible. What do you propose to avoid the conflict?
Investor: I would like a limit on the valuation used to convert the debt into equity.
Founder: Do you want to fix an upper limit on my valuation?
Investor: No. The valuation cap is not the same as the valuation. It's a cap only to convert my debt into a meaningful stake. You and your next round investors are free to set a fair valuation. If it exceeds the cap, I will have some upside for making an early investment.
Founder: I am still thinking a bit about the interest rate. And also what if I am unable to raise a round before the loan's maturity date? And I believe, we need more discussion to negotiate a fair amount for the cap and the discount.
Founder: Honestly, it's too early to tell. We have a concept and a working model. Any guesstimates will be based on a long list of assumptions. Buyer's beware, that number will have a high margin of error.
Investor: Hmm, how do I know how much stake I am buying without a fair valuation. How about I give you a loan instead?
Founder: A loan? You got to be kidding. We have no revenue. We won't be able to pay you back anytime soon. The interest rate would cripple us.
Investor: You don't have to pay me back in cash. I will roll up the interest and add it to the amount of the loan. When you raise your first equity round, convert my loan into equity.
Founder: I can do that. That sounds straightforward. But what's in it for you?
Investor: Yeah, about that. When the conversion happens, I want to be able to buy the equity at a discounted rate.
Founder: That sounds fair.
Investor: There's one more thing I would like you to do for me. If you do an amazing job at this, which I feel you will, your company's valuation can be off the roof by the time you raise a round. That's great for you, but my converted debt might end up being a tiny stake.
Founder: That would be an outcome I would push for. I mean, not to reduce your stake, but to seek for the most valuation possible. What do you propose to avoid the conflict?
Investor: I would like a limit on the valuation used to convert the debt into equity.
Founder: Do you want to fix an upper limit on my valuation?
Investor: No. The valuation cap is not the same as the valuation. It's a cap only to convert my debt into a meaningful stake. You and your next round investors are free to set a fair valuation. If it exceeds the cap, I will have some upside for making an early investment.
Founder: I am still thinking a bit about the interest rate. And also what if I am unable to raise a round before the loan's maturity date? And I believe, we need more discussion to negotiate a fair amount for the cap and the discount.
At this point, the investor and the founder have talked through what is known as a convertible note (or a convertible bond or a convertible debt). Read along to know more about SAFE.
SAFE
Investor: I see you have a few things on your mind that are bothering you. Here's another alternative. Let's drop the loan. That way, you don't have to worry about interest rates or solvency by maturity date.
Founder: What do you propose instead?
Investor: For the amount I am investing right now, you give me a right to buy equity for a future date. But I still need a valuation cap and a discount for being an early investor. But this won't be a loan, so no interest and no maturity date.
Founder: I like this better. But if you are going to have equity at a future date, don't we have to talk about all the terms of investment.
Investor: We can delay the negotiation on the terms of investment for later, just like we won't need to talk about valuation until the next time you raise equity.
Founder: That's great. I think this will also save me a great deal on legal fees for funding this.
Founder: What do you propose instead?
Investor: For the amount I am investing right now, you give me a right to buy equity for a future date. But I still need a valuation cap and a discount for being an early investor. But this won't be a loan, so no interest and no maturity date.
Founder: I like this better. But if you are going to have equity at a future date, don't we have to talk about all the terms of investment.
Investor: We can delay the negotiation on the terms of investment for later, just like we won't need to talk about valuation until the next time you raise equity.
Founder: That's great. I think this will also save me a great deal on legal fees for funding this.
At this point, the investor and the founder have changed the debt funding into equity funding known as the simple agreement for future equity (SAFE). As you can see, SAFE favors companies more than investors.
KISS
To address this, in July 2014 500Startups announced the birth of the KISS documents - Keep It Simple Security.
There are two types of KISS investments.
- Debt version: With interest rate and maturity date - these are closer to the concept of a convertible note
- Equity version: Without interest or maturity date - these are closer to the concept of a SAFE
KISS safeguards investors' interests by including:
- Most favored nation (MFN) clause: Allows the investor to get better securities in the future if issued by the company, e.g. in case of a "down round" or giving favorable terms to other investors
- Major Investors rights: Can include access to financial information, 1x participation right in all future rounds, and rights as defined in the next equity financing
- Can be transferred to anyone
References:
For Founders Raising Capital: Thinking Through the Implications of Convertible Notes
What are the key differences between the Y Combinator SAFE and 500 Startups KISS?
There are two types of KISS investments.
- Debt version: With interest rate and maturity date - these are closer to the concept of a convertible note
- Equity version: Without interest or maturity date - these are closer to the concept of a SAFE
KISS safeguards investors' interests by including:
- Most favored nation (MFN) clause: Allows the investor to get better securities in the future if issued by the company, e.g. in case of a "down round" or giving favorable terms to other investors
- Major Investors rights: Can include access to financial information, 1x participation right in all future rounds, and rights as defined in the next equity financing
- Can be transferred to anyone
References:
For Founders Raising Capital: Thinking Through the Implications of Convertible Notes
What are the key differences between the Y Combinator SAFE and 500 Startups KISS?