Future Equity Agreements for Founders14Aug2020
Future Equity Agreements are succinct agreements that are relatively economical to enable startups to raise funds in a simple fashion when they require it. Tara Chan from the Corporate and Commercial practice group of Tanner De Witt summarises and assesses future equity agreements for founders.
Future Equity Agreements are more commonly known as Simple Agreements for Future Equity (SAFEs) or the equity version of Keep It Simple Securities (KISS) agreements. The original versions of these documents were prepared according to the laws of the State of California, and need some adaptation before they can be applied under Hong Kong law.
Future Equity Agreements are agreements between the investor and company where the investor agrees to pay a certain amount for shares that may be issued to him at a later date. The shares are generally issued on the occurrence of a trigger event, such as a qualifying equity investment round or a liquidity event. Upon the trigger event, the invested amount will be used as the subscription amount for shares in the company.
Being shorter agreements, Future Equity Agreements are generally easier to negotiate. They are not recorded as debts in the accounting book. There is usually no set date of conversion. So this provides the startup with further working capital without any significant immediate obligation to the investor. In general, if no trigger event occurs, the startup is not obliged to return the invested amount to the investor.
Trigger events: Trigger events are typically change of control events, funding rounds of certain amounts, or the issuance of shares in a particular share class.
Calculations: The Future Equity Agreement will set out how to calculate or determine the number of shares to be issued to the investor upon a trigger event.
Class of shares: The Future Equity Agreement will describe the class of shares the investor will receive upon a trigger event. This will typically be the most senior shares of the company. Sometimes, the rights of the shares will also be described, which in effect will require the company to issue preferred shares, even if this was not otherwise required in the funding round.
Notice provisions: The Future Equity Agreement should require the company to inform the investor that a trigger event is about to happen and for the investor to inform the company that they wish to exercise their right under the future equity deed.
Regulatory statement: As the Future Equity Agreement could be considered a security, the Future Equity Agreement will contain a statement limiting the invitation to fund the company to the named person in the agreement.
Most favoured nation: The company may agree on terms with one investor before it has filled out the investment round with other persons. In this situation, an investor who commits early may require that he will benefit from any more favourable terms offered to later investors in the same round.
Calculation of shares
Issuance of shares to investors will generally be calculated based on two methods:
Discount: The company will grant the investor a discount compared to the share price given to other investors or purchasers who bought shares of the same share class. We have observed that the market standard for this discount is customarily between 8% to 20%.
Cap: The company will create a maximum cap limit and then divide this amount by the total number of shares issued by the startup. There are certain adjustments to calculating the shares of the startup, such as counting the total number of shares on a fully diluted basis or taking into account the shares to be issued by the startup on the trigger event.
Parties can utilise either, both or combine these methods. In general, founders prefer to offer a discount only as this usually results in less dilution to founders. Investors will seek the right to apply all calculation methods, and select the calculation method the produces the most shares.
Future Equity Agreements are conventionally only suitable for early-stage companies such as pre-revenue startups when it is difficult to value the business. As the company grows and becomes more sophisticated in its approach to financing, then a convertible loan note or full equity round will generally be favoured. Nonetheless, Future Equity Agreements occupy an important place in the funding cycle of companies.
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Disclaimer: This publication is general in nature and is not intended to constitute legal advice. You should seek professional advice before taking any action in relation to the matters dealt with in this publication.