Early stages of startup life are usually characterized by a mismatch of valuation expectations between the investors and the entrepreneurs. While entrepreneurs think about easily acquired billion dollar markets, the investors usually look at the risks and challenges they face and, therefore, hardly share the same level of optimism. Meanwhile, there is very little data to make data driven assumptions for the valuation of a company. Convertible investment instruments are introduced to address this and other issues (ease of execution, tax risks for the founders, etc.) and make seed and early stage investing relatively seamless. In essence, the valuation exercise is kicked down the road until Series A when there is much more substantial information to value the startup.
While entrepreneurs usually have inflated expectations, the investors tend to undervalue startups at the seed stage.
In this article we discuss the widely known and applied convertible investment instruments: Safe, KISS and TechStars Convertible Note; and bring to your attention the key background knowledge and parameters you should know while dealing with those.
Some need-to-know background knowledge
When a first-time founder (especially with a tech background) initially sees an investment document it probably looks like a nightmare consisting of tricky and complicated terminology. Luckily, it is not so daunting (or at least should not be). However, there is a set of concepts one needs to know in order to digest the document easily. Below is a non-exhaustive list of those concepts - make sure you understand each of them before we move on to discussing specific standardized securities:
Note that valuation cap, discount and interest can be (and usually are) used in combination.
* Pre-money valuation is the valuation of the company before investment. Post-money valuation = Pre-money valuation + the amount of investment.
Keep in mind!
Safe - Simple Agreement for Future Equity
Safe is a standard form of convertible security introduced by YC in December 2013. When investors use Safe, they buy the right to convert the convertible security (i.e. Safe) to preferred stock once an equity-financing round occurs*.
Safe has the following basic features:
There are four versions of Safe, corresponding to the four types of convertible note:
While the names of the first three are self-explanatory, the fourth requires some explanation. MFN stands for Most Favoured Nation. In this context it means that if you use Safe MFN, then you are obliged to promptly notify your investor about any subsequent convertible financing you attract. If the initial investor determines that the terms of a new convertible security issued are more attractive than those of the initial Safe, you shall amend the initial Safe to be identical to the new convertible security.
Safes are great, but they have drawbacks for the investors and therefore investors tend to avoid those (or use side letters giving them additional rights above the basic terms).
Recommended reading / materials
* Safe Preferred Stock will be a separate series of preferred stock (otherwise referred to as “shadow preferred” or “sub-series” preferred stock).
KISS - Keep It Simple Security
KISS was introduced by 500 Startups in July 2014. 500 Startups claims that those “are designed to be flexible without being overly customizable, simple while still including all of the necessary features, and balanced from both a company and investor standpoint”.
There are two types of KISS:
Below is the summary of the variables contained KISS.
You can raise multiple (series of) seed rounds - each having their number. Each series, however, shall have identical terms for all the participants.
Purchase price ($)
The amount raised from the investor
Discount from next equity financing valuation
Valuation cap ($)
Pre-money valuation of the company
Interest rate (%)
Applicable for Debt Version only. Annually compounded interest rate.
500 Startups’ preferred rate is 5%.
Maturity term (months)
The number of months upon which the conversion occurs automatically. If there is no equity round before conversion, then KISS is converted at the valuation cap.
500 Startup’s default term is 18 months.
Major investor threshold ($)
Any investor who invests more than certain amount in the given series shall be considered as Major. Major Investor has additional Information (financial and other reporting) and Participation rights (see Participation multiple).
500 Startups’ threshold is $50k.
Participation multiple (x)
Applicable only to Major investors. Major investors have the right of first offer to participate in subsequent rounds on the same terms and for the same price as all other investors in such round. If the participation multiple is more than 1, then the investor can invest more than their pro-rata share in company*.
500 Startups uses 1x by default.
Corporate transaction payment (x)
Corporate transaction means either of the following:
• the sale, transfer or other disposition of substantial part of the Company’s assets,
• merger or consolidation of the Company with or into another entity,
• liquidation, dissolution or winding up of the Company.
Corporate transaction Payment is equal to X times the Purchase Price plus all accrued and unpaid interest (if Debt Version).
500 Startups uses 2x multiple by default.
Qualified financing threshold ($)
Not each equity financing qualifies. You usually agree some minimum threshold amount. Any amount raised below that will not trigger a conversion event.
Why this threshold? Remember the purpose of convertible note - postponing valuation to a later stage when the company is mature. Hence, if you raise another small round, it is reasonable to assume that you have not reached sufficient maturity to price your company.
500 Startups’ default threshold is $1m.
In addition, KISS provides with MFN protection by default.
Obviously, the KISS is a bit more complicated but much more balanced and investor friendly (compared to Safe).
* Assume you have 10% in the company and 2x participation right. When the company raises $500k, you have pro-rata participation right to invest $500k x 10% = $50k. However, because of the 2x participation right, you can invest $50k x 2 = $100k in that round.
Techstars Convertible Promissory Note (Bridge) Financing
Techstars Promissory Note is a publicly available form introduced by Techstars in 2011. The notes are framed around two basic documents:
The first one governs the general terms of the financing round (applicable to all investors of the round), whereas the second one contains the terms of investment of the particular investor. The Agreement usually contains an appendix with a list of all the Notes issued under that Agreement.
The main differences with KISS are the following:
Applicability in ArmeniaTechnically you can attract investment to a company incorporated in Armenia through KISS, Safe or any other instrument governed by foreign jurisdiction. However, in such case it is recommended to add an arbitration clause to resolve the disputes through a specified arbitration process. Note that Armenian legislation is very pro arbitration, and additionally Armenia is party to Convention on the Recognition and Enforcement of Foreign Arbitral Awards and foreign arbitration is enforceable in Armenia.
Keep in mind, though, most of the countries foresee denomination of the stock in national currency. In Armenia the shares need to be denominated in Armenian drams (the national currency of Armenia), so the issue of currency conversion needs to be discussed at the note issuance and subscription stage.
On a separate note, it is better to start seeking any form of investment after incorporating in a jurisdiction that is preferable to your follow-on investors. In the tech startup world Delaware is one of the expected jurisdictions unless your investors are bound to certain geographic, regulatory or other restrictions. Depending on the specificity of the process, clients, investors etc., it sometimes might be advisable to establish a company somewhere else (e.g. if the market is Iran or Russia, or if the investor is from Europe, then Luxembourg, the Netherlands or the Ireland could be expected incorporation jurisdiction).
Our recommendation is that you consult with a lawyer in Armenia before entering into any such agreement.
Closing remarksWhile the deal is very important, let’s keep first things first. At the end of the day, what matters most is not the details of deal terms but the capability of the team and winning the game. People are not saying "He got a 4x liquidation preference." They're saying "He invested in Google." (Paul Graham). Hence, above all, both entrepreneurs and investors should seek mutual understanding and trust.
We at SmartGateVC are always happy to help entrepreneurs within our orbit and are open to give advice. We also seek to level up our ecosystem through sharing our knowledge and experience.
Disclaimer: This is not a legal or financial advice, and for more specific issues, we suggest to consider consulting the specialist. The purpose of this guide is to explain in general terms different models used in the startup world, and it is to be understood as a general introduction, rather than advice. We do not bear any responsibility for any harm or damage which may raise from use, non-use or wrong use of the information described in this post.