The Importance of the Most Favored Nation Clause in SAFEs and Convertible Notes

What is a Convertible Note?

A convertible note is a type of debt that converts into equity at a later date. This can happen either at a pre-determined valuation or at the time of a future funding round. Convertible notes are often used by early-stage startups as a way to bridge financing between rounds of equity or used as in lieu of a predetermined valuation. Effectively, this provides a way for entrepreneurs to kick the can down the road with respect to valuation.

The components of a Convertible Note are term, typically two years; interest rate, typically around 4%-8%; valuation cap, not always applicable; and discount rate, usually somewhere between 10%-20%. It is important to note, however, (in contrast to a SAFE, which really functions as a warrant) that this is debt, so that an investor does maintain traditional creditor rights and can force a startup company into bankruptcy, if such startup defaults on a convertible note.

What is a Most Favored Nation Clause?

The Most Favored Nation clause is a contractual provision often included in investment agreements (for the purposes of this article, we will focus on SAFEs and Convertible Notes), which state that the terms of the agreement cannot be worse or less than the terms given to any other investor. These clauses are typically more investor friendly, and as a result, can result in more dilution for entrepreneurs and co-founders.

In SAFEs and Convertible Notes, Most Favored Nation provisions are often included in order to protect investors in the event that the company is acquired or raises additional funding at a later date. While these clauses may seem unfair to founders, they are often necessary in order to get investment from early stage investors.

For example, let’s say an entrepreneur raises $100,000 with a $2,000,000 Valuation Cap and then subsequently raises another $100,000 from a different investor at a $1,000,000 Valuation Cap. Because the entrepreneur/startup has granted more favorable terms to another investor within such SAFE/Convertible Note Series, his Most Favored Nation clause would kick in and provide the first investor with such lower valuation cap. Thus, the $1,000,000 Valuation Cap would apply to both investors in the series.

It is important to note that Most Favored Nations clauses are not limited to SAFEs and Convertible Notes. These clauses can be included in any type of investment agreement, and are often used as a way to protect investors from adverse terms in future financings. This is typically broader than the scope of MFN clauses, as providing a blanket most favored nation clause on all subsequent financings would provide the original investors with too much power and the enforcement of such clause would be dependent on how it is integrated within such startups organizational documents.

In general, it is never advisable to grant a blanket, perpetual Most Favored Nation clause (that is not limited to a limited series of financings), as the results could be catastrophic for the entrepreneur/startup, and this is far outside of the industry standards.

How can a Most Favored Nation Clause be used Generally?

To break down as to how a Most Favor Nation clause could be used generally for early stage investors (including investors of SAFES/ Convertible Notes), we have included the below bullets:

• Some early stage investors want to ensure they receive the best economic terms a startup is offering to any of its other seed investors, and typically do this by entering into a side letter containing a most favored nation provision.

• A Most Favored Nations clause requires the company to give an investor with an MFN the benefit of any more favorable terms the company offers to investors in subsequent convertible note or SAFE rounds before a conversion event occurs.

• If later instruments have some terms that are better and some that are worse from an investor’s perspective than earlier instruments, MFN provisions may be structured to provide investors with those rights.

For example, if an earlier lead investor (Investor X) has an MFN clause within his agreement and the terms of that agreement set a Valuation Cap of $5 Million, and six months following that closing another lead investor (Investor Y) demands and receives a more favorable $3 million Valuation Cap, at that point, Investor X’s MFN provision would contractually obligate the company to either:

(i) to give Investor X the benefit of a $3 Million Cap;

(ii) let the investor exchange the note with a $5 Million Cap for a new note with a $3 Million Cap;

(iii) allow the investor to rescind the transaction and get his/her/its money back; or

(iv) amend such note with the consent of the company/startup and such investor.

This is just one example of how the Most Favored Nation crovision can benefit early stage investors. By ensuring that they receive the same or better terms as later investors, MFN gives them a measure of protection against being diluted by subsequent rounds of financing.

Founder and Investor Due Diligence 

It’s important to note that not all startups include a Most Favored Nation provision in their SAFEs/Convertible Notes. In some cases, it may be because the founders don’t want to be beholden to any one investor, and would prefer to have more flexibility when it comes to negotiating future instruments within the same series. In other cases, it may be because the startup is confident that it will be able to raise subsequent rounds of funding on more favorable terms.

If you’re a founder raising money for your startup, it’s important to be aware of the potential consequences of including a most favored nation provision in your SAFE and/or Convertible Note round. While it may give investors some peace of mind, it could also end up diluting your own equity stake in the company down the line or could result in a difficult situation. Of course, any most favored nation clause can be amended with the mutual consent of the company and the founder.

Ultimately, it’s up to each individual startup to decide whether or not to include a Most Favored Nation provision in their seed round financing. As an investor, you should weigh the pros and cons of this clause before deciding whether or not to invest.

Conclusion

The Most Favored Nation clause s an important tool for protecting the interests of early stage investors and can be a useful tool for entrepreneurs to use in connection with their convertible note and/or SAFE offerings. This clause ensures that an investor will receive the best possible terms when compared to any other investors in subsequent rounds of funding. While not every startup includes a Most Favored Nation clause in their seed round financing, as an investor you should weigh the pros and cons before deciding whether or not to invest.