Venture Terms Part II of II
M. James Faison, attorney at the Faison Law Group, discusses convertible securities. Convertible securities play a crucial role in early-stage startups through flexible financing options.
These securities typically fall into three primary categories: Convertible Notes, KISS (Keep It Simple Securities), and SAFE (Simple Agreement for Future Equity). While they share many similarities and can often be customized to look nearly identical, a key distinguishing factor is when they convert into company ownership.
A convertible note resembles a form of debt and has three potential times for conversion: upon its maturity date, upon qualified financing, or upon a change of control. The maturity date and the accruing interest element make it akin to a traditional loan, although, in essence, it is not. Typically, startups do not have the funds to repay in cash, so the interest that accrues is converted into equity in the company. This makes the convertible note unique among its peers.
On the other hand, SAFE offers two scenarios for conversion: during a qualified financing event or a change of control. Unlike convertible notes, SAFE agreements do not carry a maturity date or interest, and so they do not operate like debt. The conversion into equity in a SAFE agreement only occurs around significant events.
KISS agreements provide flexibility, allowing for incorporating debt-like elements such as a maturity date or a structure more similar to a SAFE with no such date. The choice of structure often depends on the specific requirements of both the startup and the investors.
Critical features distinguish these convertible securities and determine whether they should be considered debt or equity. These features include the maturity date and interest rate, both of which give convertible notes their debt-like characteristics. Additionally, certain provisions can greatly influence the attractiveness of the agreement to early investors. Understanding the nuanced differences between convertible securities is vital for startups seeking early-stage financing.