Advantages Of An ACE
It is Not a Debt Instrument
Unlike a convertible note, an ACE is not a debt instrument. The advantage of this is that the ACE does not create the risk of insolvency, there are fewer regulations to incorporate into the document (that would otherwise apply to a debt instrument) and there is no maturity date.
It Does Not Accrue Interest
Because the money invested via the ACE is not a loan, it will not accrue interest. This is particularly beneficial for startups. This also reflects the true intention of the investor, who never sought to be lenders in the first place.
It Saves Startups Money and Time
As the ACE is a more simplistic security type it overcomes many of the difficulties associated with convertible loan notes. For example an ACE has no interest rate, maturity date or repayment obligations (with the exception of a dissolution or liquidity event). These advantages should save start ups both time and money with regard to legal fees and time spent negotiating.
When Will The ACE Purchase Amount Convert To Equity?
The primary triggers for the conversion or termination of an ACE are generally an “Equity Financing”, a “Liquidity Event” or a “Dissolution Event”. The actual number of shares the ACE will convert into will have to be calculated in accordance with the agreed terms of the ACE. If none of the above events occur prior to the “Anniversary Date” the ACE-holder will have the right to “Review” the ACE and the start-up’s progress and can choose to:
(i) convert all or any part of the Purchase Amount to common stock at a conversion price set out in the ACE, or; (ii) allow the ACE to remain unconverted and review the ACE on a future date as determined by the Investor.
It is important to note that SOSV’s intention is not to seek our investment amount back. We invest in your startup at an early stage with the intention of building a long term supportive relationship to help you build and scale your company over a period of 10 years or so. Our ultimate goal is to maintain equity in your company whilst it grows and becomes more valuable as opposed to seeking our original investment amount back from your company.
Conversion Upon an Equity Financing
The ACE will generally contain a clause allowing for automatic conversion of the purchase amount when the startup achieves an Equity Financing. An Equity Financing is generally a stock financing round by the startup to raise capital from investors in exchange for shares in their company at a predetermined level for Equity Securities.
Equity Securities are usually the class of share in a qualifying equity round (normally preferred stock), for example a Series Seed round. Once the Equity Financing level, is raised by the startup, the ACE will automatically convert to the Equity Securities.
What If The Valuation Cap In The Next Equity Financing Is Higher Than The Valuation Cap In The ACE?
SOSV would get a number of shares of preferred stock calculated using the Valuation Cap as set out in our ACE. The higher valuation cap of the next round would not be used to calculate our conversion.
However, the preferred stock issued to SOSV as an ACE holder will have a liquidation preference that is equal to the original ACE investment amount, rather than based on the price of the shares issued to the investors of new money in the financing. This feature means that the liquidation preference for ACE holders does not exceed the original investment amount (a 1x preference).
What If The Pre-Money Valuation Of The Company In The Equity Financing Is Lower Than The Valuation Cap In An ACE?
The Valuation Cap is inapplicable in this situation. An ACE holder gets the same preferred stock, at the same price, with the same liquidation preference, as the other investors of new money in the financing whilst applying the discount as per the ACE.
What Happens To An ACE If The Company Goes Public?
If a company goes public, an ACE will convert into shares of common stock calculated based on the Valuation Cap (or the ACE holder can cash out the ACE).
Repayment Upon A Liquidity Event
A liquidity event is generally a good thing for the company. With this in mind we seek a higher return on investment than we would in a Dissolution Event for example. Generally a liquidity event includes a change of control, an acqui-hire or an, Initial Public Offering (IPO). If a liquidity event occurs prior to the expiration or termination of the ACE then the startup will generally be liable to pay the Investor the greater of:
(i) twice the purchase amount, or; (ii) the amount the Investor would have received in connection with such Liquidity Event had the Investor’s purchase amount converted to equity immediately prior to the effectiveness of the Liquidity Event
Most people don’t realize that, for example in an aqui-hire situation the founders do very well via stock options in the purchasing entity, enhanced salary levels, etc. while startup programs and angel investors do not get their money back. This clause aligns the investors with the founders so that investors can get some level of return on their investment.
Repayment Upon A Dissolution Event
A dissolution event is quite different to a Liquidity Event in that it generally means that the startup has voluntarily or involuntarily decided to dissolve or wind up the company. In this case SOSV has a Liquidation Preference.
A Liquidation Preference provides protection to SOSV as SOSV will seek to have a preferential entitlement to, generally, a 1x liquidation preference, which would be equal to the direct cost of having a company in the startup development program via program costs & equity investment monies.
We invest in companies with the view to being involved with these companies for the next 7-10 years while building a strong relationship with the founders and the company. Put simply, this clause ensures that we can recover the costs of putting you through our program, so that we can find a new long term investment for the next program.
What Factors Determine The Percentage Equity Upon Conversion?
The amount of Equity Securities that the ACE can convert into will depend on the share price of the next round and two key elements – the Discount Rate and the Valuation Cap. Both of these clauses give the ACE holder the benefit of being one of the first to invest i.e. a maximum price that will be paid (Valuation Cap) or a discount on the price the next investor is paying (Discount Rate). Without the Discount Rate or the Valuation Cap, the ACE would essentially convert into the Equity Securities at the same price as the equity issued in the next round. The Discount and the Valuation Cap are provisions that attempt to remedy this.
The Discount Rate
The discount rate acknowledges that the ACE holder has taken on additional risk in investing at such an early stage in the startup. The ACE holder gets a level of protection on the basis that the ACE holder will have the entitlement to a discount against the future stated value of the company at the time of conversion. The discount rate 20%.
The Valuation Cap
The valuation cap (the “Capped value”) again aims to acknowledge the risk taken by the early stage ACE holder as an investor in your company. The valuation cap sets the MAXIMUM price into which the ACE will convert to equity in the startup – essentially protecting the ACE holder by setting a limit on the conversion price of the ACE so that the ACE holder is guaranteed a minimum number of Equity Securities if the subsequent priced equity round is above the Capped value level.
If the next round is at a valuation level below the actual Capped Value, then the calculation may not be relevant. The Capped value is generally consistent with what the Founders consider the valuation of their startup is at the time of the ACE. Remember, the Capped Value is the maximum price that the ACE can convert. Founders should remember that if the ACE converts at the Capped Value this is generally a good sign as the actual valuation of the Company at the time of conversion is probably greater than the Capped Value.
The ACE will convert at either the discount rate or the valuation cap, whichever results in the best (i.e. lowest) price for the investor.
What Does The Anniversary Date Mean?
The Anniversary Date is generally 12 months after the effective date of the ACE. If an equity financing has not been raised within this time period SOSV will have the right to either: (i) convert to common stock in accordance with the terms of the ACE or (ii) allow the ACE to roll forward for a certain period of time at SOSV’s discretion.
Where it is clear that a company is making good progress and an Equity Financing is on the horizon we are happy to let the ACE roll forward but this is at the Investor’s discretion on a case by case basis.
What Are Information Rights?
We know that founders are busy developing and progressing their companies but there are real benefits to be gained from sharing information, not only for Investors but also the founders themselves.
The information prepared will help in building the relationship between your Investors and the company, will allow transparency and will maintain open channels of communication between you and your Investors.
The preparation of regular updates (financial and otherwise) also focuses the minds of founders and allows founders to assess if the company is growing at the projected pace, if there are areas that require specific attention, identify strengths and weaknesses, etc.
Once a channel of communication is opened it avoids any nasty surprises or shocks. It is no coincidence that the best performing companies at SOSV are those that have always been open and transparent with information. As well as illustrating wonderful discipline, it shows us as investors that the founders and company have a really solid handle on their financials, strategy, customers, products and vision. This frequently gives us confidence in the company when future funding rounds come around.
Why Do We Need A Founders’ Agreement Now?
The moment you decide to take your idea and make it a reality, you and your co founders’ should sit down and draw up a proverbial pre-nup! Just like any partnership, it is everyone’s intent that everything runs smoothly, but things change so it’s best for all parties to decide on the “What If’s” now.
What Is A Founders Agreement And What Are The Key Issues To Consider When Completing A Founders’ Agreement?
A Founders’ Agreement is a clear, uncomplicated written agreement between the founders outlining the understanding and expectations of each party on a number of key issues such as:
- Equity Ownership
- Roles and Responsibilities
- Decision Making
- Intellectual Property
- Board Procedures
It allows the founders to build a solid foundation and nurture one of the most important relationships as a co-founder.
Many co-founders think that splitting equity evenly is the fairest and easiest way to maintain harmony in the camp. Whilst this approach is understandable it may not be the wisest decision once all matters are considered.
It is important to remember that all equity should be subject to vesting which I will discuss further below. Vesting means that rather than receiving all shares in one lump sum, the shares are held by the company pending the completion of certain milestones. For example, after one year of service 25% of the founder’s equity will vest and the remaining equity will vest on a monthly basis thereafter over a number of years as agreed.Here is a list of factors to take into consideration when considering how to divide the equity:
- Who developed the idea or original IP
- Sweat equity i.e who has earned equity through their work
- Who is integral to building value
- Cash contributions
- Roles and responsibilities
- Industry experience
The importance of vesting provisions are demonstrated in the event of a sale of the company, which had a founder who quit prematurely. With the protection of vesting provisions the quitting founder would only be entitled to benefit from the sale proceeds to the extent of the value that they added during their time in the Company i.e. to the amount of the fully vested shares in his/her name prior to departure. By way of example, if there are two founders with 40% ownership of the company each, and they’re vesting is over four years, and one founder quits after one year, they’d only have vested 10% of that 40% (one quarter of their shares). So the other 30% of the company would be repurchased by the company (and perhaps re-issued to a replacement co-founder).
SOSV is committed to our companies long-term, and we want to see benefit accruing to founders who demonstrate their long term commitment to the startup. Vesting facilitates this and all investors seen order to ensure that founders stick around over time, vesting permits the startup to retain the right to repurchase (at a nominal value), some or all of these founder shares in the event that a founder decides to quit the company.
The vesting of founders’ shares should be seen as “founder-friendly” and should be implemented in the form of vesting schedule in order to protect each founder & the company. Vesting provisions will ensure that all founders are focused on achieving ultimate success for the startup.
A standard vesting agreement would have equity vesting over 4 or 5 years, with the first 25% of shares vesting after one year and the remainder vesting in monthly or quarterly increments. Standard vesting provisions would allow an additional year of accelerated vesting in the event of a sale, merger, consolidation, etc., provided that such founder is still with the company at the time of sale, and would have contributed to the value being added that attracted the interest of a purchasing party.
The options granted from the ESOP are generally subject to similar vesting provisions (except in that case the options are just cancelled instead of the issued stock being repurchased).
Roles and Responsibilities
Whilst founder roles and responsibilities can be broad at the beginning and can change over time you should set out the main responsibilities each founder will be accountable for. A comprehensive job specification is not required however the most important duties should be prioritised and agreed upon.
Remember, the founders’ agreement and designation of roles is a moving piece that can be amended and molded to suit the company’s needs over time.
Whilst decision making procedures can be daunting and uncomfortable at first, they can be broken down into regular procedures such as, weekly reviews of operational expenses and larger decisions such as capital spending or hiring and firing.Some of these decisions are simple and can be assigned to one founder to manage whilst other decisions are more substantial and may require a decision making procedure involving all co founders.
With regard to spending and as referenced above it is a good idea to designate the everyday operational spending to one person however there should also be a high level review of this function on a monthly or bi-monthly basis with the intention of tweaking the process to cater for the growing needs of the business. Larger spending may require a different approvals process whereby all founders must be consulted.
With regard to hiring and firing it is not only the hiring and firing of employees that should be discussed. What happens in the event that a founder needs to be let go i.e they are not performing etc. You may want to consider events that would necessitate the use of a mediator, arbitrator or another independent third party to help in reaching workable solutions for the tough questions.
100% of the intellectual property (IP) must belong to the company. This means that the company will own all registered IP ( patents, trademarks, trade secrets, design rights etc) and all IP held by the founders, employees and/or consultants with regard to all work and projects conducted for the benefit of the company.
In addition to including an IP section in your Founders’ Agreement, it is important that you sign a Confidential Information and Invention Assignment Agreement. This ensures that all IP, in all forms, whether registered or merely in the realm of idea’s and concepts are the property of the company and shall remain the property of the Company whether the developer of the IP remains with the company or not.
When considering your Board Procedures you should draw up a list of matters that require a majority or unanimous board consent. Below is a list of matters to consider:
- Changes to the certificate of incorporation or bylaws
- Stock grants, transfer or shareholder distribution
- Borrowing or lending money
- Adopting an annual budget
- Hiring or terminating members of senior management or amending salaries or other material ter ms etc.
- Adopting employee benefit plans
- Will there be a casting vote or will each director have an equal vote
- Who will act as chairperson
SOSV suggests that founders use arbitration as a means of dispute resolution in their Founders’ Agreement. Arbitration is an alternative dispute resolution mechanism to the court system. Any judgment is binding in nature and effectively has the same impact as a court ruling. The main difference is that arbitration tends to resolve disputes quicker than the court system and is potentially more cost effective for both parties.
Founders can choose the law and venue of any potential arbitration in advance. The law and venue can be the same or they can be different based on the founders’ needs i.e. if the entity is incorporated in Delaware the founders may pick Delaware law to apply to the proceedings, but if the founders are based in California they may choose that the arbitration is held in California albeit subject to Delaware law.
In SOSV’s experience time is of the essence for early stage companies, especially with regard to third party funding. If a dispute arises it is important for the Company and the founders to have a pre agreed dispute resolution mechanism in place. If there are no such mechanism in place, alot of time and energy can be spent whereby both parties are trying to agree next steps in the midst of a very difficult situation, all the while the focus of the Company is taken off it’s business, decreasing the Company’s chance of recovering after/if the dispute is resolved.
What is a Post-Money SAFE
What is a SAFE?
A SAFE is a Simple Agreement For Equity. In exchange for immediate investment, the Company agrees to give the Investor the right to an equity stake in the Company at a later date.
Unlike a loan agreement or convertible loan note, a SAFE is typically non repayable and is interest free.
You will often see a SAFE with a discount and/or a valuation cap. For the purposes of this example however we are referring to a fixed percentage SAFE, meaning it is explicitly agreed that in exchange for the investment amount from the Investor, the Company will issue an exact percentage of the Company’s stock to the Investor in accordance with the terms of that SAFE. Therefore there is no explicit valuation cap or discount, it is simply a fixed percentage SAFE.
What does the term “post-money” mean?
“Post-money” refers to how and when the SAFE will convert to equity. The advantage of the post-money structure is that both parties know the exact percentage equity the Investor will receive once the SAFE converts to equity.
Usually, a post-money SAFE will convert to the agreed-upon exact percentage ownership immediately prior to the Company’s next equity financing, i.e., the SAFE will convert after all other outstanding instruments in the Company (loan notes, options, issued equity etc.), but before the new money in the equity financing.
You can find more information detailing the pre-money vs post-money approach in this helpful blog post by Carta.
Example of how a post-money fixed percentage SAFE converts to equity:
SOSV invests $275,000 into ABC on 1st of February 2022 using a post-money SAFE.
The SAFE provides that immediately prior to an “Equity Financing” (as defined in the SAFE and explained below in this FAQ) the $275,000 investment will convert to x% of the “Company Capitalisation”.
The definition of Company Capitalisation in a post-money SAFE usually looks something like this:
“Company Capitalization” is calculated immediately prior to the Equity Financing and (without double counting, in each case calculated on an as-converted to Common Stock basis):
- Includes all shares of Capital Stock issued and outstanding;
- Includes all Converting Securities;
- Includes all (i) issued and outstanding Options and (ii) Promised Options; and (iii) an Unissued Option Pool of at least 10%;
- Excludes, notwithstanding the foregoing, any increase to the Unissued Option Pool in connection with the Equity Financing.
This means that all shares (common and preferred) issued and outstanding, all convertible instruments issued, and all options (i.e. the ESOP) are included in the calculation of SOSV’s post-money equity holding. Please note this is just an example for discussion purposes only – the definition of Company capitalization may vary and change over time from contract to contract.
Ultimately this means that immediately prior to the equity financing, SOSV’s equity will represent the exact pre-agreed percentage as set out in the SAFE. Very soon thereafter the new money from the equity financing and increase in the ESOP (if any) dilutes the SOSV (and all other stockholders) equity stake in the Company. The level of dilution will depend on the price per share and amount of new money in the Equity Financing.
How is the investment amount structured in SOSV Programs?
The investment is broken into (i) Cash Amount, and (ii) Program Costs.
- Cash Amount
The cash investment is paid directly to your Company, usually on a tranched basis, over the course of the Program. The SAFE will set out:
- how the cash amount will be paid i.e. via bank transfer in US dollars;
- when the cash amount will be paid i.e. $X,000 on arrival at the Program and execution of the SAFE, $X0,000 on day 30 and so on;
- any milestones that must be met before a tranche of the cash amount will be paid.
- Cash Amount
- Program Costs
The program costs are paid directly to the Program on the Company’s behalf.
This portion of the investment generally covers access to space, labs, lab equipment, mentorship and access to specialized materials.
What Events Trigger Conversion Of Investment To Equity?
The events that trigger the conversion or termination of an SAFE are as follows:
- Equity Financing
- Liquidity Event
- Dissolution Event
- Review Conversion
When any one of the above events happen, the SAFE will, generally speaking, terminate and in the case of say an Equity Financing, the relationship between SOSV and the Company will be governed by a new set of investment documents. All of the above are explained further below.
What Is An Equity Financing?
An equity financing consists of the immediate sale of stock to third party investors in consideration for a minimum US dollar threshold amount known as the “Equity Financing Threshold”. The Equity Financing Threshold varies depending on each Program, but is usually between US$500,000 and US$1,000,000. Once you have completed the SOSV Program, one of the main goals for your Company will be to raise an equity financing within the first 12 months of signing the SAFE.
Convertible Debt is not counted towards the Equity Financing Threshold. This approach advocates for the raising of a solid equity round rather than gathering or “stacking” convertable instruments which may be detrimental to founders (Pros and Cons of Convertible Debt).
The actual number of shares the SAFE investment amount will convert to is calculated by multiplying the pre-agreed percentage by the Company capitalisation. The term Company capitalisation (as explained in the “What is the Post-Money Safe” section” will be defined within the respective SAFE and will basically set out all the different factors used in the relevant formula to calculate the SOSV percentage of your Company’s equity.
Can SOSV convert the SAFE if the Company does not do an Equity Financing?
From the Equity Financing section above you will see that the SAFE automatically converts to equity when you hit the Equity Financing threshold. The definition of Equity Financing also provides for an optional conversion mechanism which means that SOSV can, at its discretion, convert the SAFE to the agreed equity percentage if your Company raises an equity financing round that is less than the required Equity Financing Threshold.
Why? Well, for example if you raised just below the Equity Financing threshold instead of an amount at or above the Equity Financing Threshold, then SOSV may consider converting at that point rather than wait for another future round at or above the Equity Financing Threshold.
If an Equity Financing or Optional Conversion does not occur prior to the Anniversary Date (which is usually about 12 months from the date the SAFE was fully signed/executed) SOSV will have the right to review the SAFE and the Company’s progress and can choose to:
- convert all or any part of the SAFE investment to common stock based on a fixed percentage of the Company capitalisation (as defined in the SAFE); or
- allow the SAFE to remain unconverted and review the SAFE on a future date as determined by SOSV.
What Is A Liquidity Event?
A liquidity event is generally a good thing for your Company.
Generally a liquidity event includes a change of control, an acqui-hire or an Initial Public Offering (IPO). If a liquidity event occurs prior to the conversion or termination of the SAFE then the startup will generally be liable to pay the SOSV the greater of:
- a multiple of the SAFE investment amount; or
- the amount SOSV would have received in connection with such a liquidity event if SOSV’s purchase amount converted to equity immediately prior to the liquidity event.
Most people don’t realize, for example in an acqui-hire situation the founders do very well via stock options in the purchasing entity, enhanced salary levels, etc. whereas financial and angel investors do not get their money back. This clause aligns the investors with the founders so that investors can get some level of return on their investment.
What Is A Dissolution Event?
A Dissolution Event is quite different from a Liquidity Event discussed above in that it generally means that your Company has voluntarily or involuntarily taken steps to dissolve or be wound up. In this case, SOSV has a Liquidation Preference.
A Liquidation Preference provides a preferential entitlement to, generally, a 1x liquidation preference, which would be equal to the direct cost of having financed and supported the Company through the relevant SOSV program via program costs and direct cash investment.
SOSV invests in companies with a view to being involved with these companies for the next 7-10 years while building a strong relationship with the founders and the Company. Put simply, this clause ensures that SOSV at a minimum can recover the costs of putting your Company through the program, so that SOSV can find a new long term investment for the next program. This is a fairly standard and very modest level of protection for any investor in this scenario.
What is a Pro Rata Right?
As your Company continues to grow and raise additional financing, the ownership percentage of all of the existing shareholders (founders and investors) will be diluted. The aim of the pro rata right is to allow the existing shareholders (usually investors, like SOSV), at their discretion, to purchase additional shares or convertible instruments at the market rate at that time to maintain their percentage ownership.
Under the terms of the pro rata right as detailed in the SAFE (either a direct right attaching to the equity into which the SAFE converts, a right to participate in a convertible instrument round before the SAFE converts, or by a separate “Pro Rata Rights Agreement”), SOSV is entitled to acquire further equity in future financing rounds, based on the price and terms of such financing rounds, generally to maintain SOSV’s pro rata (pre-financing) equity percentage in your Company.
SOSV’s pro rata right right demonstrates both SOSV’s interest in maintaining its percentage ownership in your Company over time – from the very early stages right through to a potential sale – as well as SOSV’s intention to develop an ongoing, open, and productive relationship with your Company. SOSV has a history of maintaining its pro rata share (if not more!) in SOSV portfolio companies.
The benefit to your Company in granting pro rata rights is that it is easier to raise future financing rounds with an existing investor who is committed to following on. Any new investor will want a capitalisation table that is working for the benefit of the Company so that rather than having investors who are “one round and done,” you are generally better off having investors who are happy and capable of following on at higher valuations in future funding rounds. Other investors look favorably on such committed existing investors.
What Is A First Financing Right?
SOSV reserves the right to invest further into your Company up to the greater of 20% or US$200,000 of any financing either:
- prior to an Equity Financing where the Company enters into a convertible instrument or convertible round; or
- upon an equity financing (where your Company issues shares immediately).
SOSV only gets to exercise this right once. It does not live on in perpetuity. Remember that it is up to 20% or US$200,000, meaning SOSV may participate for 5%, 10%, or 20% of the debt or equity round, at SOSV’s sole discretion. This is good for your Company as other new investors will generally like to see existing investors inject more cash into your Company.
What are Information Rights?
SOSV will have the right to certain information pertaining to the Company. These include, unaudited financial statements, budgets and brief monthly updates.
The preparation of regular updates (financial and otherwise) help to focus the minds of founders and allows them to assess many factors such as; whether the Company is growing at it’s projected pace, are there areas requiring specific attention and what are the Company’s strengths and weaknesses, etc. The information provided will also strengthen the relationship between SOSV and the Company by creating transparent and open channels of communication.
It is no coincidence that the best performing companies at SOSV are those that have always been open and transparent with information. As well as illustrating wonderful discipline, it shows all investors (including SOSV) that the founders and the Company have a solid handle on their financials, strategy, customers, products and vision. This frequently gives SOSV (and all investors) more confidence to participate at full pro-rata in the Company’s future funding rounds.
What Is An Observer Right?
SOSV does not take a board seat at such an early stage in the Company’s life however SOSV may take an observer seat. This means that SOSV reserves the right to appoint an observer to attend board meetings. This observer right does not grant any voting rights at such board meetings.
The reason SOSV asks for an observer right is so that we can add additional value to your Company, understand the operation of your Company, help your Company with tough decisions especially when you are in the process of granting a director seat to another investor or third party and need someone in their corner to help negotiate or advise them on what is reasonable in certain instances, especially at the earlier stages of your Company’s life cycle. SOSV sees itself as aligned with the founders (given the early stage of our investment and program structure) and as such SOSV wants to be able to contribute and share with you its wealth of experience from investing in so many companies (over 1000) in such a consistent period of time on a global basis.
What Is a Most Favoured Nations Clause?
This right, a.k.a “MFN”, means that if the Company grants more favorable rights than those that exist in the SOSV investment instrument(s) either (i) 60 days prior to entering into the SOSV SAFE, or (ii) after SOSV invests into your Company and prior to conversion of the SOSV instrument – then SOSV may choose to adopt those particular more favorable rights in addition to its current rights.
What Is A Put Right?
The Put Right states that at SOSV’s discretion and upon conversion or ownership of shares in the Company may choose to sell back its equity holding the shares to the founders of the Company for the nominal amount of $1. There is no onus on the Company to repay the full investment amount to SOSV however in order to transfer the shares back to the founders. The $1 is simply a nominal payment or consideration for this transaction.
It is an unfortunate reality that many companies in which SOSV invests will not go on to secure tangible future value. They will either dissolve or will just become stagnant with no further financing progression since SOSV’s initial investment. Of course, this risk is mitigated greatly by the value added to the Company over the course of the Program.
What Are The Program Participation Requirements?
SOSV’s Programs are designed to help your Company realize its maximum potential. Obviously the Program itself cannot do the work for you. Rather, we provide expertise, mentorship, certain technical or scientific resources and advice in the form of a 4-5 month program. It is also the starting point of a long-term relationship between SOSV and the founders. With this in mind, SOSV expects all teams to fully participate in the Program and be onsite (or remote depending on various circumstances) at the Program on a daily basis. SOSV knows that there are sometimes meetings and trips outside the Program that cannot be avoided but on the whole, if you are on the Program, it is expected that you will give it your full attention and participate fully in the itinerary of the Program in order to get the maximum benefit for you, your team and your Company.
What Happens If A Participant Is Removed From The Program?
There is language in the SAFE setting out the Program’s expectations of you to participate in the Program. For example, it is expected that you will participate in the Program in a collegiate manner, that you will give the Program 100% of your time and you will terminate all other employment.
The Program’s investment amount is tranched and each tranche is attached to a milestone of some sort. SOSV’s desire is that all selected teams will flourish over the course of the Program and that there would never arise any need to ask a team to leave. However on extremely rare occasions if the relevant Program Director believes, based on failure to meet milestones, failure to participate fully in the Program (i.e. missing meetings, failure to show up to the program on a consistent basis, engaging in anti social behaviour etc.), or such other reasonable grounds, the Program Director may have to ask the founders and their Company to leave the Program.
If a Company is ejected from the Program the Company will be liable to repay the total investment amount received to date, including program costs. If the Company is not in a position to repay the investment amount SOSV will retain all rights in the Company in accordance with the rights contained in SAFE.
What is an Employee Share Option Plan (ESOP) or Unissued Option Pool?
An ESOP or unissued option pool is a pool of stock from which options can be issued. Options are basically a right to purchase shares in the Company at a future date. They can be given out to employees, directors, advisors, officers, service providers, etc.
SOSV requires each investee startup participating on an SOSV Program to create and maintain an ESOP of at least 10% of the Company’s total issued stock on a fully diluted basis right up until immediately prior to an equity financing. An ESOP enables a cash-strapped startup, that may not yet be in a position to offer market-rate salaries, to attract high-caliber employees, by affording the opportunity to those candidates to earn equity in a potentially successful startup, combined with an initially modest salary.
An ESOP can give employees the incentive to commit to the startup in order to achieve ultimate value through their ESOP holdings. Employees will experience the value of their contribution over time as the Company’s stock value increases as a whole.
An example of how SOSV’s investment and creation of an ESOP, may interplay with the founders’ equity is set out below.
|A. All Issued and Reserved Shares prior to creation of the ESOP||B. All Issued and Reserved Shares prior to SOSV investment||C. All Issued and Reserved Shares as of the date of the SOSV Agreement|
|FOUNDER A||3,872,000 (55%)||3,872,000 (49.39%)||3,872,000 (48.40%)|
|FOUNDER B||3,168,000 (45%)||3,168,000 (40.41%)||3,168,000 (39.60%)|
|EMPLOYEE SHARE OPTION PLAN (“ESOP”)||0 (0%)||800,000 (10.20%)||800,000 (10%)|
|SOSV IV LLC||0 (0%)||0 (0%)||160,000 (2%)|
|TOTAL||7,040,000 (100%)||7,840,000 (100%)||8,000,000 (100%)|
- The total number of shares issued on the date of SOSV’s investment is 8,000,000 (Column C);
- The ESOP is 10% on a post investment basis.
- The founding team’s shareholding is deemed adequate as of the date of the investment. In the event another founder is required or additional equity needs to be reserved for another founder or key employee, the Company may need to reserve additional shares in the ESOP.
Can The Agreement Be Assigned?
The SAFE cannot be assigned by the Company without SOSV’s express prior permission.
SOSV can assign the SAFE amongst its “Affiliates” as defined in the Agreement. Simply put, SOSV will not assign the SAFE to any party outside the SOSV group. SOSV invests in companies via a certain fund and from time to time we may have to assign certain investments between those internal funds or companies.
What Is A Stock Purchase Agreement (“SPA”)?
An SPA is an agreement which records the terms under which shares of stock (common or preferred) are issued to SOSV by a program participant Company.
What Does Anti-Dilution Protection And Qualified Financing Mean?
As per the terms of the SPA, the Anti Dilution Protection clause ensures that SOSV can maintain its equity percentage for no further consideration until the Company has raised an agreed minimum amount of future funding (e.g US$500,000). This is also known as an Equity Financing.
This ensures that SOSV will not be diluted by small amounts of funding or a “family and friends round” where the amount of funding raised is below the Equity Financing threshold.
This provision should encourage startups to raise appropriate funding which meets the Equity Financing threshold as soon as possible.
What Is A Pro Rata Right?
Under the terms of the pro rata rights as detailed in the SPA, SOSV is entitled to acquire further equity in a future financing round, generally to maintain SOSV’s pro rata (pre-financing) equity stake. This will be on the terms of the first financing investment round (negotiated at that time).
The entitlement to SOSV under the pro rata rights demonstrates that SOSV is interested not just in an ultimate percentage return but in maintaining its percentage ownership in a company in which SOSV has been involved with and committed to since its beginning.
Pro-rata rights aim to ensure an ongoing, open, and productive relationship between SOSV and the startup, and we have a history of maintaining our pro rata share (if not more!) in our companies.
The benefit to the company here is that it is easier to raise future financing rounds with an existing investor who is committed to following on. Any new investor will want a capitalisation table that is working for the benefit of the company so that rather than investors who are “one round and done” you have investors who are happy to follow on at higher valuations in future funding rounds. Other investors look favorably on committed investors.
What Does The First Financing Right Mean?
SOSV’s first financing right enables us to participate in the first qualified funding round in the startup, up to an agreed monetary/percentage cap (usually the greater of $200,000 or 20% of such new equity securities ), on the terms of such subsequent investment, with such terms to be negotiated at that time. We’ve invested a tiny bit of money and a ton of time and effort, and it’s important to us that we can stay in the game as the company moves to the next level.
Most startup programs don’t have the ability to fund companies that graduate. This is not an advantage for the participants. SOSV has the ability to provide and/or match first funding rounds post-program. This makes it easier for our graduates to close their first funding round.
We have a history of backing our companies, through good times as well as bad, and this clause helps ensure we can continue that. In the upcoming HAX program this clause has been extended further to include a matched funding promise, if you can raise $200,000 from another Investor, then we will match it!
What Is An Employee Stock Ownership Plan (ESOP)?
An ESOP is a pool of stock from which options can be issued. Options are basically a right to purchase shares in the company at a future date. They can be given out to directors, advisors, employees, officers, service providers, and just about anybody.
We require that each investee startup create and maintain an ESOP of at least 10% of the company’s total issued stock on a fully diluted basis. An ESOP enables a cash-strapped startup, that may not yet be in a position to offer market-rate salaries, to attract high-caliber employees, by affording the opportunity to those candidates to earn equity in a potentially successful startup combined with an initially modest salary.
An ESOP can give employees the incentive to commit to the startup in order to achieve ultimate value through their ESOP holdings. Employees will see the value of their contribution over time as their stock value increases.
Key Considerations When Deciding Where To Incorporate
A question we get asked on a regular basis is: where should I incorporate? An interesting question with lots of possible different answers and solutions. There are a number of considerations with regards to incorporation:
- Fundraising: Where are your Investors?
- Trading: Where is your product being manufactured & sold?
- Grant availability: Is there non-dilutive funding available for locating in certain areas?
- Residence: Where do you live or where are you entitled to live?
Each of these will have an impact on where you incorporate. US Investors do not generally invest into entities that are incorporated outside of the US (A Delaware C-Corp would be the standard investment entity used in the US). This is due to onerous tax filing and information requirements on US citizens for off-shore investment activity.