[ Sorin is Chair of the Venture Capital and Emerging Growth Company Practices at McCarter & English]
There has been unprecedented change recently in the landscape that governs methods by which startup and emerging growth companies can raise capital and investors can deploy it. That’s a good thing. The dynamic regulatory climate governing private company fundraising – see, e.g., SAFEs, Reg A+, etc. – creates opportunities (and challenges) for players on both sides of the ball.
It seems like only yesterday we pondered the merits and drawbacks attached to SAFEs (Simple Agreements for Future Equity). To review briefly, the merits – as our investor and issuing company clients made clear – are that SAFEs are inexpensive and simple (as their name suggests), and more closely align the form and substance of the investment with the risk/reward profile associated with early stage company investments. The drawbacks also are clear - SAFEs lack even the most basic forms of investor protection associated with convertible note and priced equity financings, and, not surprisingly, institutional investors have been largely unwilling to embrace SAFEs. At least for now, while early stage companies and entrepreneurs are eager to learn about and adopt SAFEs. They continue to be utilized primarily by investors who are themselves entrepreneurs, other individual angel investors and the proverbial friends and family.
Now, in an attempt to acknowledge and neutralize that investor-side skepticism about SAFEs, our intrepid friends, colleagues and counterparts from the West Coast have blown us a KISS (Keep It Simple Security). The KISS – essentially a hybrid that attempts to employ the best of company-friendly SAFEs and the slightly more investor-friendly convertible notes -- seeks to level the playing field.
Let’s take a closer look at what the KISS offers and why investments might be structured that way.
* KISSes can be structured to accrue interest at a stated rate and establish a maturity date after which the holder may convert the underlying investment amount, plus accrued interest, into a newly created series of preferred stock, even in the absence of a subsequent priced equity round by the company. They also may provide additional rights to qualifying investors – most commonly, information rights and the right to participate in future company financings, both of which prospective investors often find appealing.
* As presently fashioned – and we’re in the early days of KISSes, so tweaks will be forthcoming; stay tuned – KISSes come in two varieties. One more closely tracks a convertible debt structure; the other, an equity financing structure. The two are similar in all respects except that the latter does not accrue interest, so it may actually represent an attractive middle ground between SAFEs and the KISSes that more closely resemble convertible debt.
* The most notable difference between KISSes and SAFEs is that the newcomer contains some downside protections that are standard in most convertible note financings but absent from SAFEs. That is sure to catch the eye of investors – particularly those east of the Mississippi and those higher on the investor food chain – who have continued to shy away from SAFEs.
* They require negotiation on more points than SAFEs do, resulting in higher transactional costs – seemingly a reintroduction of a shortcoming associated with convertible notes. They revert to the traditional convertible debt formulation of accrued interested and conversion (or repayment) upon maturity, without regard to the objectives of early-stage entrepreneurs and investors. And they require founders to spend precious time, energy and resources complying with administrative covenants in the KISS documents.
Is a KISS a better instrument than its predecessors? That depends on how you measure and whom you ask. Truly, it’s a matter for the free market to decide – only the entrepreneurs who demand capital and the sophisticated investors who supply it will ultimately determine which mechanisms will gain traction and enjoy sustainable use and which will be relegated to the sidelines.
Will it get traction? Probably – slowly at first, perhaps, as wary players dip a toe in the water.
Depending on who embraces KISS as a level-playing-field mechanism, it could end up being simply one more arrow in the quiver – the answer to certain fact patterns where the entrepreneur’s and investor’s needs coalesce around it. After all, if there is one certainty about early stage investing, it is that a single solution or security does not fit all circumstances and specific needs and goals of disparate entrepreneurs and investors. Unlikely though it may be, the KISS also could take off faster than a certain hard rock band in the Seventies whose members painted their faces, wore platform shoes and performed under the same name.
For now, we won’t KISS the SAFE goodbye. The more tools that our marketplace has at its disposal, the better chance that entrepreneurs and investors can make deals that benefit both. We welcome the hybrids that exist now and those not yet on the horizon. And we’ll be sure to save a kiss for ongoing attempts that seek to make capital-raising easier, cheaper and more efficient, all to the betterment of innovators, investors, the economy and society as a whole.