INSIGHTS

Effectively Managing SAFE/Convertible Noteholders When Raising Your First Priced Round

February 2, 2022

The proliferation of SAFEs (Simple Agreements for Future Equity) and Convertible Notes (collectively, “Convertible Securities”) over the past few years has given rise to a new problem when raising your first priced financing (whether its titled “Series Seed” or Series A”) – sometimes known as “party rounds”.  In 2010, the typical seed stage company had anywhere from 0 – 10 Convertible Securities outstanding.  The total size of a typical seed financing ranged from a couple hundred thousand dollars to a couple million dollars.  Managing a large group of Convertible Securities’ holders toward an equity financing closing wasn’t really a problem.  More and more, the typical seed stage company has a significant number of outstanding Convertible Securities outstanding when closing their first equity financing transaction.  We regularly see companies with 20+ Convertible Securities outstanding, with the majority being SAFEs.  The increase in use of Convertible Securities is likely due to a few reasons: (1) the development, adoption, and ease of use of Convertible Securities, (2) the general comfort of Convertible Securities and acceptance that more capital can be raised on these instruments than initially thought and (3) Series A financing metrics taking longer to reach.  Our thoughts on the best process for managing Convertible Security holders to ensure a smooth and efficient closing are below.

We recommend a six-step approach for managing Convertible Security holders.

• Step 1 is to get organized.  Create a Convertible Security holder email distribution list.  This will streamline future communications and save you from typing out individual email addresses and eliminate the risk of leaving an investor off of an email or sending an email to the wrong person, which happens surprisingly often.
• Step 2 is to communicate. Send the Convertible Security holders the final, signed term sheet.  This puts your investor group on notice that you have secured a lead investor and should have a deal closed in the next three to five weeks.  It also provides your investor group with a summary of the key financing terms, which will help speed up their review of the financing documents once available.  We’d encourage this email to be carefully worded, as the Convertible Security holders do not have the right to negotiate. Generally, we would not expect any correspondence or questions from the investor group, other than congrats on securing the term sheet and requests to participate in the new round.  The Convertible Security holders should be excited their SAFEs or Notes will be converting at a discount to the price per share at the financing.
• Step 3 is to provide updates. We recommend sending the investor group the drafts reflecting the initial changes from the lead investor’s lawyer, not the initial drafts prepared by company counsel.  When sending these draft documents, you should note that they are not yet final but reflect the lead investor’s comments.  You should also note that you expect to close in couple weeks and will be following up with the investor group with final documents and a request for signature. Again, this message is not invitation to the investor group to provide their comments, but rather a way to show progress on the financing and give an expected timeline to close.  The lead investor sets the terms – it would not be practical to negotiate on an individual basis with all of your Convertible Security holders.
• Step 4 is to follow-up with the final versions of the transaction documents. We’d recommend sending redlines showing any changes from the documents that were circulated as part of Step 3 to enable the investor group to expedite their review.  You should also provide the investor group with the target closing date and let them know you will be sending an electronic signature request (e.g., DocuSign, HelloSign, etc.).  Some investors may require side letters or need specific changes to the financing documents, which is inevitable and will have to be taken up on a one-off basis. The vast majority will sign the closing documents as-is.
• Step 5 is to send the electronic signature requests.  Once you have all of these signatures in hand and have finalized all deal documents with your lead investor and filed your amended charter you are now ready to close your Series A financing.
• Step 6 is to close the loop post-closing.  Now that you have closed, do your investor group the courtesy of sending them the fully-executed transaction documents.  They will want these for their records and appreciate you handling this in a timely manner.

The above approach is an effective means for managing Convertible Securities stakeholders.  The overarching principle is to communicate early and often with Convertible Security holders.  Your law firm should be able to take many of these steps off your plate and run this process for you.  Whether you adopt this approach or take a different strategy, the important part is getting all your Convertible Security holders on the same page.  If you don’t, you run the risk of delaying your closing.  No investor likes to be caught off guard with a last-minute request to sign complex and long legal documents.