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

Most Favored Nation Provision

Short Answer:

The Most Favored Nation clause ensures early investors in startups (via SAFEs or convertible notes) receive terms equal to or better than future investors, protecting their interests and preventing dilution in subsequent funding rounds.

Introduction & Background

My extensive background in securities law, coupled with my firsthand experience navigating the complexities of startup financing, positions me as a leading authority on innovative investment mechanisms like SAFEs (Simple Agreement for Future Equity) and convertible notes. My legal expertise, honed over years of advising startups and investors, provides me with a deep understanding of the strategic importance of instruments that allow startups to raise capital efficiently while offering investors a potential for significant returns. This insight is particularly relevant in the context of Most Favored Nation (MFN) clauses, a critical element in protecting the interests of early-stage investors by ensuring they receive the best possible terms in future financing rounds.

The MFN clause represents a pivotal aspect of investment agreements, safeguarding investor value by adjusting terms to match more favorable conditions offered in subsequent financings. Drawing from my experience, including my role at a prominent startup accelerator and as a venture capital attorney, I’ve seen firsthand how such clauses can influence the dynamics of startup funding, providing both protection and potential pitfalls for founders and investors alike. My journey through the intricacies of convertible notes and SAFEs, combined with a keen understanding of the broader investment landscape, empowers me to demystify these complex financial instruments for entrepreneurs and investors, ensuring they are leveraged effectively to fuel startup growth and innovation.

What is a SAFE?

SAFE is an acronym for “Simple Agreement for Future Equity.” It is a type of investment agreement popularized by Y Combinator, a popular American startup accelerator company. A SAFE allows entrepreneurs to raise capital without giving up equity or going through a lengthy and costly fundraising process.

Instead, SAFEs are structured as convertible debt instruments; meaning that they convert into equity at a later date. This gives investors the potential to earn a higher return if the startup is successful, while also providing entrepreneurs with much-needed capital upfront.

SAFEs have become increasingly popular in recent years, and are now used by many early-stage startups as a way to quickly raise seed funding.

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.

investor MFN

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.

most favored nation clause

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.

To learn more about SAFEs, Convertible Notes, or the Most Favored Nation clause, contact our law firm today at 904-234-5653 or fill out our contact form.

The information provided on this website does not, and is not intended to, constitute legal advice; instead, all information, content, and materials available on this site are for general informational purposes only. Securities law is complex and highly fact specific to any given circumstance and readers should contact an attorney for advice regarding any type of legal matter.

Legal Disclaimer

The information provided in this article is for general informational purposes only and should not be construed as legal or tax advice. The content presented is not intended to be a substitute for professional legal, tax, or financial advice, nor should it be relied upon as such. Readers are encouraged to consult with their own attorney, CPA, and tax advisors to obtain specific guidance and advice tailored to their individual circumstances. No responsibility is assumed for any inaccuracies or errors in the information contained herein, and John Montague and Montague Law expressly disclaim any liability for any actions taken or not taken based on the information provided in this article.

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