Only recently, we debated the merits of the SAFE (Simple Agreement for Future Equity), an alternative funding mechanism for early-stage companies designed to replace the industry-standard convertible note financing (click here to read our alert “Better SAFE Than Sorry? A New Way to Finance Start-ups”). While SAFEs enjoy support from many in the start-up community (e.g., accelerators, entrepreneurs, and tech-savvy angel investors), most venture and other institutional investors have largely eschewed them for their lack of even the most basic forms of protection associated with convertible note and priced equity financings. We now consider the newest debt security replacement making its way over from the West Coast: the KISS. The KISS is probably best described as a hybrid – seeking to embody the simplicity and ease of use of SAFEs with some of the investor protections associated with convertible notes.
Recognizing that venture capital investors derive the greatest value – and highest returns – from the equity into which their debt securities convert, and not from the 6-to-10 percent coupon common to such notes, prominent West Coast start-up accelerator Y Combinator developed the SAFE as an alternative to the convertible promissory note financing structure. In their standard form, SAFEs provide that the underlying investment converts into equity of the issuer upon certain events, such as a preferred equity financing, an IPO, and/or a change-of-control transaction. Unlike convertible debt securities, however, SAFEs neither accrue interest nor convert into common stock (or, worse for founders, require repayment) at a stated maturity date. Investors are unable to declare a SAFE in default and seek repayment. Generally, the only negotiating points in a SAFE transaction are the inclusion and amount of a valuation cap and a discounted price on conversion. SAFEs, in theory, are attractive to both early-stage companies and their investors, then, because they allow companies to avoid carrying debt on their balance sheets, can be completed with lower attendant transaction costs, and more accurately reflect the realities of investing in early-stage companies. As a result, SAFEs have gained traction in the West Coast start-up community and are now making their way east. Since our most recent client alert on this issue, members of our Venture Capital and Emerging Growth Companies practice have helped early-stage tech, tech-enabled, and life sciences companies consummate roughly half a dozen SAFE transactions.
Because many in the investment community, especially institutional investors and corporate partners, shun SAFEs due to their lack of investor protections, particularly in the event the company does not raise future rounds of equity capital, and the perception that SAFEs are disproportionately issuer-friendly, we now see the introduction of the KISS.
The KISS (Keep It Simple Security) represents a step toward integration of the SAFE with certain elements of the more investor-friendly convertible debt mechanism. While similar in many respects to the SAFE, the KISS contains certain downside protections standard in most convertible note financings that are absent from SAFE transactions. Specifically, KISSes 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 of the company. KISSes also may provide additional rights to qualifying investors. Most commonly, they provide investors with information rights and the right to participate in future company financings. As presently fashioned, KISSes come in two flavors; one more closely tracks a convertible debt structure, and the other an equity financing structure. The latter is similar in all respects to the former, except that the equity KISS instrument does not accrue interest, so it may actually represent an attractive middle ground between the SAFE and the convertible debt KISS instrument.
While KISSes respond to investors’ main concerns regarding SAFEs – namely, lack of interest rate and downside investor protections – we hesitate to declare that KISSes will become the go-to alternative security for early-stage investment transactions; in fact, the KISS may not even overtake its cousin, the SAFE, as the most popular convertible note alternative in the early-stage company financing tool kit. To that end, we have not yet seen KISSes gain the traction that SAFEs, and before them, convertible notes, have enjoyed in the marketplace. Y Combinator developed SAFEs to “replace convertible notes in most cases … [and] address many of the problems with convertible notes while preserving their flexibility.” KISSes, however, reintroduce many of the shortcomings of convertible notes that SAFEs were designed to overcome. They contain additional points for negotiation, thereby increasing transaction costs and decreasing simplicity; they revert to the traditional convertible debt formulation of accrued interest and conversion upon maturity, without regard to the objectives of early-stage entrepreneurs and investors; and they require founders expend precious time and energy complying with administrative covenants in the transaction documents. Were Shakespeare a member of the venture capital community, he may well have asked of KISSes: “What’s in a name? That which we call a [convertible promissory note] by any other name would smell as sweet [as your run-of-the-mill convertible promissory note].”
Regardless of whether the KISS attracts as much interest within the investor community as the SAFE, let alone the convertible note, options abound for founders and investors alike hoping to raise, or contribute, early-stage capital. Let’s face it, a basic tenet of innovation and entrepreneurship is that founders almost always need to obtain seed and other early-stage funding to achieve their goals. And SAFEs, KISSes, convertible notes, and even plain vanilla seed equity financings are critical and valuable tools for growth-stage companies looking to take their business to the next level, and for investors to help them get there while enjoying an appropriate return on capital.
So today, we won’t KISS the SAFE goodbye. We do, however, welcome the ongoing attempts to make capital raising easier, cheaper, and more efficient to empower entrepreneurs to employ risk capital to spur innovation, create jobs, increase productivity, and build wealth. Whether in the form of a SAFE, a KISS, a convertible note, or priced equity, capital resources are the main source of fuel for the innovators creating new products, services, and solutions that benefit our economy and all of us.