At SOSV we believe in transparency — especially when it comes to our funding. We also believe in the power of educating our startups right from the get-go to equip them with the knowledge they need to grow their companies. With this in mind, we thought it would be useful to provide an overview of our ACE instrument (unique to SOSV), focusing on the positive contribution an ACE can make to your company’s progress, and on the importance of understanding how an ACE will impact your cap table going forward. This overview will be broken into a couple of key areas:
What is an ACE?
An Accelerator Contract for Equity (ACE) is an SOSV instrument facilitating investment directly into a company. This investment should then convert to a class of stock at a later date.
An ACE is a straightforward document designed to be as company friendly as possible towards an early stage company, allowing you to concentrate on growing your company rather than jumping through costly legal and administrative hoops.
An ACE is similar to a convertible loan note (CLN) only without the debt and without the interest. Therefore, generally speaking, repayment is not an issue (unless there is a liquidity or dissolution event). Just like the CLN, however, the ACE should convert to equity at some point. The key events causing an ACE to convert to equity are discussed below.
Key Conversion Events
It’s important to understand how and when the ACE converts to equity in your company:
(a) on conversion to preferred stock (or the same class of stock as issued in the financing) in the event of an equity financing;
(b) on conversion to common stock, at the option of the investor, in the event an equity financing does not occur within 12 months.
Equity Financing — Conversion to ACE Preferred Stock
The aim of the ACE is to convert to preferred stock as part of a financing round in your company. The most common conversion event is an equity financing. An equity financing occurs when the company has raised an agreed amount of funding from one or more investors in a sale of shares in the company i.e. an equity round (within 12 months from the date of the ACE).
Once the equity financing threshold ($300,000 or more) has been met, the ACE will convert to an equity percentage in accordance with the conversion calculations set out in the ACE.
Broadly speaking the conversion rate will be determined by:
Or
- the Discount Price Percentage (the share price of the round * 80%) as agreed to in the ACE
whichever yields the higher number of shares for the investor.
Again, be aware that the valuation cap as referred to above is simply the highest price that the ACE will convert at. It does NOT set the future valuation of your next round of equity financing.
Conversion To Common Stock (Optional Conversion)
Converting to common stock would be slightly unusual, however there may be events which dictate that this is the best course of action for both the investor and the company.
If an equity financing has not occurred the investor can decide to convert the investment to common stock. The investor may also decide to leave the ACE outstanding depending on the company’s progress and whether there is a likelihood of an equity financing in the near future.
As mentioned above, the investment will only be repayable if there is a dissolution or liquidity event (i.e. a sale) before the ACE has converted.
Remember that the investor has the right to convert using the valuation cap OR the discount — whichever yields the greatest level of equity for the investor.
Conversion Scenarios: What Happens if…
Below are some basic examples of the different conversion scenarios that may occur in an ACE that has both a valuation cap and a discount on the basis that:
- The investment amount of the ACE is $175,000;
- The valuation cap is set at $3.5 million; and
- The discount on the price per share of the next round is 20%
- The number of shares in issue prior to conversion = 10,000,000
- The pre-money valuation of your next financing round = $.50 per share
Conversion using the valuation cap:
Valuation Cap ($3.5 million) divided by the total number of shares in issued in your company on a fully diluted basis as of immediately prior to the equity financing = Price per share.
In this example = $3.5m/10,000,000 = $.35 p/share
The investment amount ($175,000) is then divided by the price per share = Number of shares to be issued to the Investor.
$175,000 / $.35 = 500,000 shares
SOSV would end up holding 500,000 shares in the company with 10,500,000 shares in issue i.e. 4.76%
Conversion using the discount:
The Discount Percentage (20% or .80 as a multiple) multiplied by price per share paid by the new investors in the priced equity financing round. In this example the discounted price per share would be $.50 * 80% = $.40 per share. Therefore the ACE would convert at the capped value ($.35 per share) as this would give the higher number of shares.
The discount is usually used when a company is raising a round with a lower valuation cap than the ACE (once the discount is applied).
Dissolution Event
If there is a dissolution event the investor will seek to receive the investment monies back in preference to other shareholders. This is similar to a liquidation preference.
Liquidity Event
If a liquidity event occurs, (sale of the company, change of control, IPO, etc) the investor will be entitled to the higher of 2x the investment monies or the applicable equity holding if the ACE had converted at the capped value.
Most Favoured Nations Clause
In addition to the above key events, some ACE agreements may include a Most Favoured Nations clause (MFN). An MFN clause aligns the ACE agreement terms up with any other investor who may invest in a similar manner in the future. Simply speaking it grants the ACE holder the benefit of any “new” clauses which might be entered into to keep your investors and company aligned going forward.
Dilution & ACEs: Know Your Cap Table
Whilst the ACE instrument is less cumbersome than the CLN it is still dilutive in nature. You must understand the dilutive implications of an ACE or any other investment agreements that you enter into.
Broadly speaking it is inevitable that your equity as a founder will be diluted by any investment you accept. However, if the funding, mentorship, and development provided by SOSV enables you to realise the potential of your company and meet key milestones enabling your company to reach a greater level of growth, then the dilution should lead to a much more accelerated return and/or growth trajectory.
For the theory to work in your favour you must be clued in to your cap table and understand the dilution effect on your own equity, the proposed lifetime of your company, the amount of potential financing you are going to raise from investment, and the overall dilution that you will suffer as a result. What is the potential economic outcome of a successful exit for you as a founder ?
The Investor’s Perspective: The Long Game
At SOSV we enter into hundreds of convertible instruments every year. Our intention here is not to generate interest and/or repayment, it is simply to hold equity in your company in the future.
There will be a very clear expectation that your company is in a position to achieve an equity financing in the near future (within 12 months of graduating our accelerator program) which will ensure that our ACE converts.
You as founders are not personally liable for the debts of your company (as long as you have acted in an honest and ethical manner), so if the ACE is not returned or repaid in accordance with its terms, then SOSV has no recourse to you personally. Unfortunately it is a simple fact that many investments into early stage companies will not deliver any return for SOSV. We are not in the business of putting startups into default in order to reclaim some return on our monies. We are in the business of supporting and developing early stage and growing companies (at the accelerator stage) and will ideally become a long term investor into your startup that will deliver a return to SOSV, our investors, and you as founders over the lifetime of our relationship.
The ACE is an early stage investment, which is not classed as debt, does not bear interest, and is intended to be as company friendly and easy to understand as possible.
SOSV expects and hopes that these relationships will last for many years and enable very positive outcomes for the company, the world, and SOSV. The ACE is designed in order to align your company and SOSV towards these goals.
Originally published at sosv.com on July 27, 2017.