Introduction to SAFE and Convertible Notes
SAFEs (Simple Agreement for Future Equity) and convertible notes are essential components of the financing process for early-stage startups. These financial instruments serve as a flexible means for raising capital, allowing startups to avoid burying themselves in the legal paperwork required for a standard equity raise while keeping the terms of investment flexible. However, SECFEs and convertible notes often raise questions regarding the board's authority to pre-authorize conversion shares at the initial financing stage. This article explores the rationale and implications of such actions, highlighting the nuances and best practices.
The General Practice: No Pre-Authorization of Conversion Shares
Typically, the terms of SAFE and convertible notes specify that they convert into equity shares (often preferred shares) in the next qualified financing round. When such financings take place, preferred shares are issued, and the outstanding SAFEs or convertible notes convert in accordance with the predefined ratio. It should be noted that, at the time of issuing these instruments, the startup usually has no preferred shares to issue since the terms of these shares, including the total number and valuations, are under negotiation. Thus, pre-authorizing and reserving these conversion shares is not common practice.
Why a Company Might Pre-Authorize Shares
Some companies choose to pre-authorize and reserve conversion shares at the initial financing. This decision is often driven by specific structural provisions in the convertible instruments or the demands of investors. A convertible note or SAFE could be structured in a way that it converts into a specified number of common shares or preferred shares contingent on certain events, such as a qualified financing not occurring by a certain date. In such cases, the investor might insist on pre-authorization to ensure a fluid conversion process, avoiding any potential obstacles. However, this is far from a standard practice and should be a carefully negotiated solution tailored to the specific situation.
Legal Requirements for Amending the Certificate of Incorporation
To ensure that a company can issue authorized shares, it is crucial that the certificate of incorporation be updated to include sufficient authorized shares. Generally, a certificate of incorporation must specify the total number of authorized shares the company can issue. This adjustment requires a vote from the stockholders, as it is a modification to the foundational company document.
As such, it is imperative for startups to maintain a sufficient reserve of authorized shares to facilitate the conversion of convertible securities. Each time convertible securities are issued, the company is implicitly agreeing to the potential future issuance of equity. By pre-authorizing these shares, the company avoids the risk of facing legal hurdles or delays in securing shareholder approval for additional authorizations.
Conclusion
In summary, while pre-authorizing and reserving conversion shares for SAFE or convertible notes is not a standard practice, it can be done in certain specific circumstances. It is essential for companies to understand the implications of such actions and ensure that they align with the company's goals and legal requirements. Maintaining a sufficient reserve of authorized shares in the certificate of incorporation is crucial to ensuring smooth and efficient operations during subsequent financings.