Today, we are launching our version of the Series Seed documents. Fenwick & West originally created these documents in 2010 to reduce legal costs for startup financings via standardized documents. YCombinator launched their own version of the documents in 2013, and introduced the novel concept of a SAFE — a financial instrument that had qualities of convertible debt but economics of “Convertible notes with caps.”¹ Cooley open sourced their docs in 2016. All of these efforts were a huge help to make this process easier, faster, and cheaper for startups.
With Fenwick & West’s help, we created our own version. These documents reflect our business model and preferred approach to working with startups. We know that we will not use these docs in many instances. But when leading a round or investing a larger amount, we prefer to use these.
Our goal was to create a version that reflected a SAFE in economic terms and corporate governance. There are two key differences between SAFEs and preferred equity. The first is valuation — in a SAFE, the parties essentially agree to “punt” the valuation/ownership discussion by providing a cap on conversion or a discount into the next round.² The second is corporate governance (e.g., board of directors) as discussed below.
Our documents are available here. We are happy to have anyone use these documents in their fundraising. We cover the major changes below.
Valuation/Economics
The biggest difference is that we have a set pre-money valuation, post-money valuation and amount raised. Some have said that a SAFE with a pre-money valuation is the equivalent economically to doing a priced round with the same pre-money valuation. This isn’t true.
Under a typical SAFE, the investor is diluted by the Series A invest with no opportunity to invest their pro-rata. The investor may have right to invest pro-rata in Series B and beyond however the investor has lost its right to maintain their initial (or implied ownership). Let’s say a Seed_Investor invested $1MM on a $9MM pre-money cap. They think their “implied ownership” is 10% when their investment converts in an equity round. However, the Seed_Investor will be diluted by the Series A investor without a chance to invest their pro-rata.³
Now, the obvious way to fix this is to let Seed_Investor invest more in the Series A to maintain their “implied ownership” of 10%. Our documents intend to address this gap.
One might counter: “Who cares?! If the outcome is huge — a unicorn — then it doesn’t matter!!” This is largely true — especially for angel investors in our view.
This is less true if your targeted investor is managing a fixed pool of money.⁴
And that cuts to the essence of choosing an investor. Each investor will have his/her/its own incentives and approach. For any transaction, you should consider the incentives and needs of the other party if you want their best efforts.
Founder Vesting
- We have a “Founder Vesting” provision that states that founder shares vest over time. This is different from a SAFE.
- This is better for founders and companies.⁵
- One of the biggest reasons why startups fail is founder discord and breakup. As Fred Wilson wrote in 2010:
If I look back at our most successful investments over the almost 25 years that I have been in the venture capital business, almost every single one of them has seen a founder or critical founding team member shown the door as the company scaled. It’s almost inevitable.
- If you don’t have a vesting provision, it could basically kill the company if there’s founder breakup. The departing founder can effectively hold the company hostage by being dead weight on the cap table. And more importantly, it can make the departure 10x more painful by negotiating the equity the departing founder receives rather than having this pre-determined.
- We’ve been through founder breakup countless times. It sucks and it’s painful. It’s even more painful if there is no vesting provision.
No Board of Directors
At Refactor, we don’t request board seats. Our philosophy is that when a company is in its “starting” phase”, a board seat isn’t necessary. It’s not part of our strategy. This aligns with SAFEs. Other investors feel differently. There’s no right approach.
At Refactor, we think of a startup roughly in 3 phases: starting, building, scaling. “Starting” is from Seed phase to Series A — the goal is to find product-market fit. “Building” is from Series A to later-stage — the goal is to build from the initial product-market fit to find a long-term advantage (i.e., “moat”). “Scaling” is later-stage and beyond — building out the moat and creating long-term value.
No blocking rights for M&A
- We removed an investor’s right to “block” an M&A transaction. This is consistent with how a SAFE approaches this issue.
- However, investors need to approve any additional financing or anything that could “adversely change” our rights. This is different from SAFEs. We include this because we’ve been diluted in a few instances when founders raised additional convertible notes without our knowledge. We won’t unreasonably withhold consent, but we’d like to agree when a company wants to raise more money.
No Option Pool
- Historically, option pools have been used as another way to negotiate valuations, and founders have (quite literally) paid the price. In essence, any option pool diluted the founders and not the investors. See here for the best post describing the dynamic.
- Our initial approach is to take the dilution on a pro-rata basis with founders. This point resembles SAFEs.
No Exploding Term Sheet
We won’t put an expiration date on the term sheet as we know choosing investors is an incredibly important decision for founders.
Conclusion
In conclusion, we have created documents based on seriesseed.com that reflect our approach. Our goal was to maintain the structure of the SAFE but also preserve clear ownership and transparency, which we believe is better for investors and founders. Regardless of structure, founders should have founder vesting upon a financing. We are pragmatic; we won’t always use these docs given the market dynamics of each situation.
This effort is based on participating in hundreds of seed financings over our collective careers. We want to minimize the unintended consequences of legal documents. We believe that investors and founders have a better sense of the unintended consequences of priced rounds versus SAFEs strictly because they have been around for literally decades longer.
The principles that govern fundraising are simple to understand but not obvious to apply. Our goal is that these documents help founders focus on the critical points and not get lost in false dilemmas or irrelevant details in a critical and formative time for their companies.
A very special thank you to the great team at Fenwick & West in preparing our docs for us. We couldn’t have done it without Michael Esquivel, Faisal Rashid, and their team. And we are grateful to their ex-colleague, Ted Wang, who helped launch this effort while he was at Fenwick as mentioned above. Thanks to Mark, Fred and Joanne as well for reading (or telling me they read) versions of this post.
Endnotes
- This post will use SAFE and “convertible note with cap” interchangeably.
- For those who around when convertible notes first became popular (circa 2010 or so), the caps were generally equivalent to the pre-money valuation of a priced round. They were negotiated just like a pre-money valuation. The main difference was that convertible notes were faster and cheaper than priced rounds. Over time, caps have floated up to a “range of reasonableness” in many cases.
- Suppose Seed_Investor invested $1MM in NewCo at a $9MM pre-money valuation in a priced round. Pretty simple — Seed_Investor now owns 10% and has pro-rata rights to invest in the next round. Now suppose NewCo raises $10MM on a $30 MM pre-money valuation (woohoo!) from VC. In a priced round, Seed_Investor’s ownership is reduced by 25% from 10% to 7.5% unless it invests its pro-rata (at a first approximation, about $1mm). Under the the SAFE, Seed_Investor owns ~ 7.5% upon conversion and close of the Series A (at first approximation). Put another way, the Seed_Investor has lost the opportunity to invest their pro-rata in the Series A.
- Let’s say the company exits at a $1BB. Seed_Investor has a fund of $50MM. In scenario one, Seed_Investor receives $100MM and in scenario two, it receives $75MM. One might think, “BFD!!” But for this particular investor, it could matter. If you asked any institutional investor if you could have an outcome that returns half of their fund (i.e., the difference between the two outcomes for a $50MM fund), they would leap. If this isn’t clear, read here.
- Of course, founders can and should do this separately from the financing documents with a restricted stock agreement drafted by their attorneys.
