When startups look for early-stage funding, they often turn to convertible notes or SAFEs (Simple Agreements for Future Equity) because they’re quick and flexible. However, these tools come with some unintended consequences that both founders and investors should be aware of—especially when it comes to liquidation preferences.
What Are Liquidation Preferences?
In traditional preferred stock financing, investors typically get back at least what they put in before any money is distributed to common stockholders. For example, if investors put $750,000 into a startup, they get a liquidation preference of $750,000, ensuring they get their money back first in the event of a sale or liquidation.
The Twist with Convertible Notes and SAFEs
Things get trickier with convertible notes and SAFEs. When these instruments convert to equity during a later funding round (often called the Next Equity Financing), investors usually get preferred stock with a liquidation preference. However, since they convert at a discount or based on a capped valuation, they often end up with a liquidation preference that’s higher than what they originally invested.
For example, if the Series A price is $1.00 per share but noteholders convert at $0.80 due to a discount, their liquidation preference still equals $1.00 per share. This means they get a 1.25x return on their investment before anyone else sees a dime. If the next funding round values the company way higher than the cap (say $20 million vs. a $5 million cap), this could lead to a situation where these early investors get a 4x liquidation preference—something that’s very off-market and could cause tension with new investors.
Possible Solutions
To avoid giving early investors what some call “phantom” liquidation preferences, lawyers sometimes include special clauses in the funding agreements:
1. Shadow Preferred Stock: This creates a special class of preferred stock that matches the investment dollar-for-dollar, avoiding any surprise windfalls for early investors.
2. Common Stock Discount: Another approach is to give investors the full value of their investment in preferred stock and any additional shares as common stock, which doesn’t carry a liquidation preference.
While these solutions can help, they add complexity and cost to the funding process, so they’re typically used only when the valuation cap is very low or the funding round is substantial.
Anti-Dilution Protection: Another Concern
Convertible notes and SAFEs also handle anti-dilution protection differently than traditional preferred stock. In a typical equity financing, if the next funding round is at a lower valuation, existing investors are protected by adjusting their share price to reflect the lower valuation. However, with notes and SAFEs, if the next round is priced below the valuation cap, early investors can end up with an even better deal than they would with standard anti-dilution protection.
The Takeaway
Despite these potential issues, many startups still prefer convertible notes and SAFEs because they’re straightforward and fast. Founders and early investors, often friends and family, might not worry too much about these technical details, but it’s essential to understand the possible financial impact down the road. By being aware of these risks and structuring deals carefully, startups can avoid surprises and keep their growth on track.