SAFEs, Notes, and SPVs

Okay, it is with great pride that I introduce Brian Derkmaat. He has been doing, uh, supporting SDAC for a number of years and really appreciate his sponsorship and commitment with his time and treasure. So thank you very much.

Thank you, Kathy. Yeah, I've been sponsoring SDAC— thanks— since the second year. Tried to get in the first year, I was too late. But it's a real pleasure to be invited to speak here, and it's really fun actually. I work in this area, and it's fun to be in a room like this. I see lots of friends, and there's also a couple of really smart attorneys in the room, so hopefully you guys have some good questions. What was I going to say? Oh, also, is there another mic that you're— right there. Do we have someone that can pass around? Because I want to make questions real easy. Because it's a lot more fun when there's more back and forth questions than just lecturing. So cool. Thank you. So I did a brief intro earlier. I'll do it real quick right now. I'm, I'm an attorney at a law firm called Ramon Law. Ramon means pomegranate in Hebrew, and it symbolizes prosperity, abundance, which is what you all expect with your investments. I'm a corporate attorney. I've been practicing for 23 years, and I work with startup emerging growth companies. I work with investors and founders. I focus a lot of my time on early-stage financing. I also do M&A work and company formations and a bunch of other related corporate transactions. But probably my favorite is to do early-stage financing. So Neal Bloom and others asked me to talk about today what it actually means, mainly what are you buying when you, when you write a check, you pay money, what do you get? And you're buying something. What are you buying? So you're signing a legal agreement. What kind of agreement are you signing? What is the structure of this overall investment? And what do you get from it? What are the opportunities and the problems, restrictions? So I'm going to talk about that. So as investors, you may have already heard that there are a number of ways that you can invest your money. You've probably heard of Series A. You've probably heard of a SAFE, a convertible note. You might have heard of a thing called Series Seed. And then there's a genius person here in San Diego that created another alternative called Series First. I'll talk about that briefly. And there's even alternatives to those. So there's more. But the main are kind of Series A, convertible note, and SAFE. Those are the three main. And really, for early-stage financing, SAFEs dominate. When SDAC invests in a startup, it's probably going to be in a SAFE or a convertible note. But we'll talk about that. And one way that I like to talk about it, because it helps me understand, is I like to understand the history of how we got to where we are today. Why do we have a SAFE? And it's interesting to understand the evolution of the documents, because then it makes the SAFE a little more understandable. And I think that contributes to better decision-making, like why should we use this versus something else. So just to start real basic, when you invest in a company, you're buying— Neal said it earlier— you're buying equity, you're buying ownership in that company. So the way to get ownership in a company is to own stock. And there's two main types of stock. There's common stock, and there's preferred stock. Common stock, like it sounds, is just plain vanilla, the main right you get is a voting right, and your main right for voting is to vote directors onto the board of directors. Like, if you own stock in a big public company and they have their annual meetings, really what you hear a bunch of stuff, but really what you do is you vote on directors. That's about it. There are other major transactions that happen that you would vote on, like selling all the assets of the company or other major things like that, but for the most part, your main power is in electing directors., and then people talk about founder's stock. There is no such thing really as founder's stock. It's not a legal term. So founders receive common stock. So that's what founder's stock really is. Oh, and I forgot to say, I intend to go through the slides kind of quickly and spending about 15, 20 minutes, but then really just do Q&A. So, and that's where things get more interesting. This is the boring part, but once I've laid the groundwork, then we'll do Q&A and hopefully that's a whole lot more interesting. So, um, and then to back up real quick before I get to stock, you could invest in a company in a different way. Like, you could invest with debt and you could get interest on the loan, but that's not venture-type returns. You're going to get 6 or 8% on your loan, and why take all the risk that you take by investing in a startup only getting 6 or 8% return? You could just invest in an index fund and and do better than that. So when you invest in a startup, you want gigantic returns, and the only way to do that is to own stock. You'll get, you'll get the upside if the company sells for hundreds of millions of dollars and you own a portion of that, then you get that like 10x to 100x return. And so owning stock is the only way you can do that. So there's common stock, then preferred stock. Like it sounds, the word preferred means you have a bunch of preferences.. So you get all these protections and special rights when you hold preferred stock. And that's really important because you as an investor, you're not running the company on a day-to-day basis. You're not making decisions about the direction of the company. And worse, you usually own a very small fraction of the company. So even if, even if you just had a voting right, your voting right is so minuscule, you can't really affect the company. So because you're a minority and because you're outside of the company, you get all these protections. And I've just listed a few of them. One is a liquidation preference, meaning if the company sells at a not glorious exit and there's not enough money to go around, you at least get the money you put in before anybody else gets money. There's a lot of details to these things that I won't go into now, but we can do it in Q&A. You get special veto voting rights, so the company cannot do certain things without your vote. You get what's called anti-dilution protection. And then you can also appoint a board member. Bottom line, investors want to buy preferred stock when they invest in a startup. So the main question is, what is the best way for investors to buy preferred stock? So I started my career as an attorney in January 2002. And in January 2002, the only way to buy— to invest in a startup was either buy common or preferred stock. And the only way to get preferred stock was to buy what's called Series A preferred stock. It's the main set of deal documents. And they're so common and so well known that there's an online website resource called NVCA where all the templates are available for free, and they're all heavily annotated, and they're really valuable. But that deal is a mountain of paperwork. There's a— let's see the next slide. 5 main deal documents and over 150 pages for all these documents. Average legal fees for each side— so I didn't specify on the slide, but for each side, so for the company and for the investor, is about $50K, so about $100K in legal fees. It's too much for early-stage startups raising less than $5 million. There's no bright line test, but It's too much work for early-stage financing. So in 2004, somebody had a bright idea that rather than do preferred stock, we will do what's called a convertible note. Man, I'm bummed none of the animations are working. I had animations to make it a little more interesting. So there was this concept called a bridge note. So if an investor invested in a Series A, preferred stock, and then the company needs to do Series B. These are huge rounds. They take a long time. A lot of times they need money quicker than you can close the Series B. So they would have— they had this simple instrument, like 15 pages long, called a bridge note. And it was debt. So existing investors, maybe some additional investors, but a lot of times existing investors would put in a little bit more money to bridge the company to get to Series B or the next round. Hold the company over. Usually, and the investors all knew the company really well, so the agreement was simple. It didn't have a ton of reps and warranties. It was very light agreement. It could be done quick. And the idea about it was that it wouldn't last more than a year because the company would do its next round within at least 12 months. So that's what a bridge note was. And sometimes people still refer to a convertible note as a bridge note. So if you know about convertible notes, you know that they often have valuation caps. Well, back then they did not have valuation caps. They did not have a maturity date of more than 1 year. In fact, there was a California law called California Finance Lenders Law that prohibited maturity dates of longer than a year. And it's just important to know that this is a convertible instrument. It's debt. It has a maturity date. It has interest.. But the intent is the company won't pay the interest. Instead, it will convert into that next round. But it was in 2004 when they took this bridge note from the bridge application and they brought it down to early-stage first money. So no longer bridge. Now it's just called a convertible promissory note. Super simple, and it made it super easy to bring in money early stage quickly and easily. As they became used over years, they became more complex. People started getting more savvy, including the idea that, hey, investors, we're getting ripped off. Well, I should back up before I talk about valuation caps. They included what's called a discount. So if you put your money in and then your money converts into preferred stock 10 months later, well, what about a benefit to you because you came in 10 months earlier than all these other investors? So they would often issue warrants or other things. Well, one of the benefits was you get a discount. So you get like a 20% discount. So your money buys more stock because you get a discounted price. Well, what happens if maturity dates get pushed out longer and the company ends up raising its financing maybe 2 years later and the valuation at that time is really high, a lot higher than what it would have been had you invested your money today?, and you still just get your 20% discount off of this gigantic valuation. And so people started getting savvy and thinking, wow, investors are getting ripped off. So we need to put a valuation cap, which sets a ceiling at which the money will convert into the next round. So the valuation caps got introduced a few years after 2004. The maturity dates got pushed out. The Finance Lenders Law got amended and removed that restriction. And then they start adding all kinds of other rights that you find in Series A, like board rights and information rights and reps and warranties, and they start getting really burdensome. And nobody likes convertible notes anymore. In 2008 to 2010, there's a brilliant attorney named Ted Wang, and he thought of a solution was, why don't we just make Series A preferred stock a whole lot more simple? So instead of 5 main deal documents, he reduced it down to 2 main documents.. It's a whole lot simpler than Series A. It's only 2 documents. And I, I counted the pages and I'm forgetting now, but I think it was about 65 pages rather than 150. Those documents are still available and I do deals on these kinds of documents and I really like this kind of deal. But sadly, it has just not really taken off. Nobody really does. They do them, but they're not very common. The documents are freely available on GitHub. And I make a note about IRS Code 1202, and I don't know this for a fact, but I have a theory that one reason this never really took off was because IRS Code 1202 was not very important until 2016. And so people didn't care that when they invested under a convertible note, they're not actually getting stock. And I can talk about QSBS later. You have to own stock in order to get the benefit of QSBS. So when you invest under a convertible note, you don't, You don't get that benefit till you convert. Well, people didn't care about it before 2016 as much. It was there, but it just wasn't as important. So it's gained little traction. One reason might be because legal fees are still a lot higher than a convertible note. Typical legal fees can be $20,000, $25,000, maybe more, maybe less on each side. So when you compare that to a convertible note, a convertible note is still a whole lot easier. So it just didn't gain traction. So Y Combinator came up with their brilliant solution in 2013, late 2013. It wasn't used till early 2014. And what they did was they took the convertible note and they just made it more simple. So everything is getting more simple over time. People are trying to make it faster and easier and cheaper to invest in startup companies. The SAFE does that brilliantly.. It's not a debt instrument. So, when they simplified it, they stripped out the interest and the maturity date. So, it's no longer a promissory note. And the maturity date is a dangerous hammer that hangs over the head of founders of startup companies because maturity dates usually get blown under convertible notes and they create real problems. And so, because of this mess, Y Combinator figured like, they never get enforced anyway. I think this just died. Just like maturity dates, this died. The document under which you purchase or invest is a simple 6-page agreement. It's ridiculously simple. Nobody reads the pages after the first page. The main terms are all on the first page and everything else is, quote, boilerplate. That's the stuff I spend my time writing that nobody reads. But really, the main terms are on the first page. But like a convertible note, it converts later into stock. And it really take— that animation actually worked. The SAFEs have really taken off. This is the first page of one of the original SAFE agreements. This one does not have a valuation cap. It just lists the discount rate. You can see it right there where it says discount rate. So really what people pay most attention to is the blank line, which is the amount of money you're investing and the discount rate. And then Most everything else they ignore. The SAFE has become the ruler of the universe. Carta does a lot of great reports, and it reports that over 90% of early-stage deals are done on SAFEs. And what's surprising is I believe SAFEs were originally created to address early-stage, low-value investments, usually under a million. There's no requirement on dollar amount, but SAFEs are being used for millions of dollars, sometimes even $5, $10 million or more. None of the automations are working, so you guys don't get— there you go. So SAFE is dominant right now. But there are dangers. And with the simplicity and the speed at which people use SAFEs, they often overlook the complexity that underlies the simplicity. And you can really spend a lot of— you can spend hours digging into the complexity of a SAFE. I'll just mention a few, and in Q&A we can talk about more. So IRS Code 1202, just in brief, it's a code that says if you own stock in a C corporation and you meet other requirements, if you hold that stock for at least 5 years, when you sell, the gain on the sale of that stock is tax-free up to a cap of $15 million. Or 10x what you paid. It's a huge tax break. And then it was also amended last year that if you only hold for 4 years or 3 years, you get a tiered-down benefit on the tax. So you have to hold stock in a C corp for it to trigger. The SAFE in the last paragraph claims that it is treated as equity under a number of IRS codes, including IRS Code 1202. So when a policeman pulls me over on the freeway and says, you were speeding, I say, no, I wasn't. I was going 55. Can't write me a ticket. So the SAFE says, this qualifies for IRS Code 1202. I think that's just as effective of me telling the police officer I wasn't speeding. So it might have more teeth to it. There is actual substance. It does have equity-like rights. For example, if distributions are made, a SAFE holder gets distributions. But it doesn't have voting rights and it's called the Simple Agreement for Future Equity. That kind of damns the whole thing right there. The argument that it's equity, it's for future equity, but there's been no IRS ruling on the status of SAFEs. And so if I were a taxpayer who invested under SAFE and I had an exit, I would of course claim 1202 benefits and let me get audited. But then there is a risk that you'll get audited and you won't get the benefit. With a convertible note and a SAFE, they convert in the future. And there's a bunch of stuff that can happen. And so, nobody knows how much equity anybody owns, including founders, until it actually converts. So, there's an enormous amount of cap table hell that ensues with convertible notes and SAFEs. And the more notes and SAFEs that pile up, the more confusing it gets. There's a thing called zombie SAFEs or zombie companies. So the intent of a SAFE or convertible note is the company will do a Series A financing. Well, what happens if they never get to that point? Some companies are really good companies, like Neal talked about, an apparel company maybe that reaches $10, $20, $30 million in revenue, but it's not like venture scale. And so there can be a lot of companies that are really good companies doing good business, generating good revenue, but they never do a Series A. And so if you're a SAFE holder, there is no mechanism in the SAFE to actually force something to happen. With a convertible note, you have a maturity date. With the SAFE, it can just sit there forever. Then finally, there's this thing called full ratchet anti-dilution, and we can get into the details on that. So the SAFE does not have full ratchet anti-dilution, but the, the way that it converts can be deemed to be similar to full ratchet anti-dilution.. And it's extremely punitive to founders. It's so punitive that even though— so I'll just explain real briefly. If you do a round of financing like a Series A financing at $1 a share, but then you later do a down round where you sell Series B preferred stock at like $0.80 a share, anti-dilution provisions will kick in and will give the original Series A investors an adjustment to what's called a conversion price, and they will be made somewhat whole. So the typical way to do that is called broad-based weighted average, where you take into account all of the shares. But full ratchet will fully ratchet the conversion price down to the 80-cent price without any mercy, basically. So there's a lot more details we can get into, um, but it puts the A investors at the 80 80-cent price, essentially, without any kind of waiting. And you'd think this is advantageous to investors and they would want it, but it's so detrimental to companies that it even hurts investors. And so investors don't even want to insist on it when you do preferred stock deals. But for some reason, everybody's comfortable with it in a SAFE. So most SAFEs have what's called a valuation cap, and most convertible notes have valuation caps today. And a lot of people say, well, the company's too early stage. We don't want to do a priced round. We can't set a valuation. But they put valuation caps on the SAFEs and notes. So, a good question is, to what extent does a valuation cap reflect the thinking of a priced round? It's not included in valuations. Like, if you get an external valuation, the valuation cap of a SAFE will not set a valuation. So, it is true, it's not a true valuation, but it gets pretty close. So, we can talk about that later too. I like quoting this investor, Fred Wilson from Union Square Ventures. It's a well-known VC fund. At some points in history, it has been rated as the number one VC fund in the US. He wrote a blog post in 2017, and then again he recapped the whole thing in 2019. So there's a link to it. He hates SAFEs and notes and he made it very clear and he just said, let's, let's get rid of all this confusion and nonsense. Let's just return to how we did it in the good old days. And when he made this recommendation, the only way to really do that was to use Series A preferred stock docs or maybe Series C. Neal Bloom. I decided just for fun to include more quotes from that blog post because he doesn't hold back on his criticism of safes and nodes. He drops an F-bomb later on in the thing and he calls the whole thing a shit show. So I would encourage you to click the link. You'll get copies of these slides. You can click the link and read his whole blog post. But he makes a really good point, especially here. That, well, this point about the more SAFEs and notes that a company does, they build up like a house of cards. And then when the investors and the attorneys who do Series A deals, they see this replay over and over and over where everything finally resolves and everybody's pissed off. So how do we avoid that? What if there were a better alternative? You would issue preferred stock. You'd get rid of the conversion nonsense. You'd keep it super simple because the market is rewarding simplicity, even though there's a ton of dangers like eating McDonald's food. People go to it like moths to the flame and they destroy themselves eating McDonald's, but they do it anyway. So people invest under SAFEs because it's simple and easy and cheap. So, what if you could issue preferred stock on a 6-page purchase agreement? That would be a miracle. You'd get IRS Code 1202 treatment. You'd get clarity. You wouldn't have zombie issues. And you wouldn't have full ratchet problems. It would be brilliant. Somebody invented this thing called Series First preferred stock. And it's nirvana. This is the first page of the agreement. It's super simple, and it lays out all the deal terms right there on the first page. It's 6 pages long. It's ridiculously simple. You can get documents for free at this website.

Who's the superhero that created it?

I did. Yes. But I'm not a salesman of this, and I'm not actually pushing it. There are good reasons why you would not use this and why you still might use a SAFE. The bottom line is you should know about this. You should know about alternatives. You should really know. You should be conscientious about what you're doing. You shouldn't just follow the trend and just do a SAFE because, quote, "Everybody's doing SAFEs." You should know the different terms and the different opportunities and risks of each and make a wise decision. Sebastian has just left the room, I think, but his firm Mintz also created an alternative not long after I created mine. And this chart is hard to see here, but if you click on that link, it's a blog post I wrote. There's more details than in these slides. And there's a chart there that, that on the left side of the table is all the main deal terms of all the different instruments. So there's up on the top is Series A, Series C, SAFE, my Series First, and then Mintz created what's called the Series SAFE. And then there's another firm, used to be called Frost Brown, they merged recently. They created a thing called SAFE Preferred. The Series First, the MINTs, Series SAFE, and the SAFE Preferred are by no means well known. They're completely unknown. And so, the biggest hurdle, even if they're brilliant, the biggest hurdle with using those is just people aren't familiar with them. So, it may take years before these become known and used. But it's good to know about it. Last thing I wanted to talk about before we do Q&A is Neal Bloom asked me to talk about what's the difference between investing directly versus through an SPV. And some people, if you're like me, when you first heard the term, you're like, what's an SPV? What's a syndicate? So I just wanted to cover that real quick and we can ask Q&A on that too. But basically, SPV is a special purpose vehicle. It's an entity that's formed just to invest in one company. A VC fund will form a fund, an entity, usually an LLC or a partnership. That's an entity, and a bunch of investors will invest in that fund, and then that fund will invest in a bunch of startups. An SPV is like that, except it's formed to invest solely in one startup. So typically, uh, it's a Delaware LLC or a limited partnership. There are platforms that host these things and will even provide all the deal, all the documents to form the entity. So I listed a few of the most common. And then the word syndicate, it just is— means— well, I think Neal does this. He's not in the room, but Neal would be a syndicate. Syndicate is usually a person called like usually referred to as a GP, a general partner. They will form multiple SPVs to invest in multiple startup companies. And if they're like on AngelList, they can have a syndicate platform where you can follow them and you can see about deals they're doing. So some of the key differences, one is the cost is different. If you directly invest, there's obviously no management fees or anything to manage this entity. But if you form an SPV, there are costs to form that SPV. SPVs are often formed with terms that are similar to VC funds, meaning there's a management fee, There's a carry. So just briefly, a carry is kind of a profit interest that the, the, the promoter of the fund gets. If the fund is successful, there's $100 million, the, the GP will get 20% of that before money is distributed back to investors. So SPVs often have carries in them. And then the platform, if it's hosted on one of those platforms, there are costs to be on that platform. And then it's also important to note that if you are an investor in an SPV, you probably will not have voting rights that you would have if you directly invested into the startup company. The SPV itself will have voting rights, and the manager, the GP of that SPV, will exercise those voting rights. But rarely do investors into the SPV have their own voting rights. There's a huge advantage, though, is this allows more investors to invest. You can go on AngelList, and you can be part of syndicates and SPVs SPVs, and you can write checks as low as $1,000, you can start investing in startups. And this is often great for the target company because if there's like 20 investors who want to invest in the startup, they all go into the SPV, and then there's only one investor on the cap table for the startup. And I'm pretty sure, um, SDAC invests through— they create an SPV, right, every year to invest in the startup. So I think we have still almost half an hour, which I'm happy about because now the fun starts. So I went through all of that pretty quick, and there's a lot of details we can dig into. But I hope seeing the history of the development of these things made it a little more understandable. And feel free to ask any questions and drill down into more details, including why you would use one or the other. Of these investment vehicles. And I think we have another mic, right? And if it gets boring, then maybe one of the attorneys has to ask a difficult question.

Always illuminating. Thank you, Brian.

Yeah, thanks, Bobby.

I still learn things. I do have a question. Sometimes— I don't know if this year you allowed it. Do you allow the LLCs to sign up? They could be LLCs when they enter, right? And they convert. Okay. So Brian, do you have any advice? Because they're going to go through due diligence of, you know, you see an LLC and what does that really mean? And what's the conversion and what's that conversation? Maybe you could give some of your experience and insight.

Yeah, that's a good question. So in startup world, if you're a new founder and you're looking at forming your entity, if you go online or you talk to people in startup community, they'll all say you have to form a Delaware C-Corp. That's the vehicle. And there's a lot of truth to that. You could form in California, you could form an S-Corp, you could form an LLC, but you have to have a C-Corp in order to create preferred stock. And then a C-Corp gives you the advantage of IRS Code 1202 QSBS stock. There are a ton of advantages to a C-Corporation. Then why Delaware? I don't get to it, LLC, but why Delaware? Delaware's laws are different than California. Each state has different laws. And Delaware set out over 100 years ago to become the best state in the nation for corporations, and they maintain that even in recent years with heavy criticism. They recently amended their law on interested director transactions to compete with Nevada and other places. That are trying to take their business. So Delaware C-corps are the main vehicle, but there can often be very good reasons to form an LLC in your initial stages. And so I do a lot of early-stage startup formation, and surprisingly, I form a lot of LLCs even for venture path companies because you might not need a C-corp during your first year or two.. But I never recommend that you must do an LLC or must do a C-Corp. I talk to founders about the pros and cons of each and which would fit their trajectory better. So a lot form with LLCs. So then if they're an LLC, and just real brief, an LLC is greatly different than a corporation. And one way it's different, it's got what's called pass-through taxation. So instead of being taxed at the entity level, the owners are taxed at the individual level under partnership taxation. And there's a lot of drawbacks. And institutional funds have restrictions and cannot invest in LLCs often. And then other investors don't want to, even if they could. They would get what's called an IRS Form K-1, and they would have tax obligations on the revenue of the company. And then also LLCs, again, they're not C-corps. They can't qualify for IRS Code 1202.. And they can create preferred classes of equity ownership, but it's not straightforward like it is with a corporation. So LLCs are not favored when you're doing venture-type investments. And so the question is, what if an investor— like, finally getting around 10 minutes later to your question— so what if an investor wants to invest in an LLC? And maybe some of these companies coming up is an LLC. So it's a good question. If the, if the company is going to issue preferred stock and you want IRS Code 1202 treatment, then the LLC must convert to a C corp. And so there is a mythology among investors that in order to invest, the company must convert to a C corp. And I think it's mythology because it's based on this idea that, yes, Delaware C corps are better and you have to have them for preferred stock. And of course you get QSBS, all this, but it's not necessary. Especially if you do a convertible note or a SAFE. Because like I mentioned earlier, the SAFE and the convertible note, they convert in the future into equity. So if the company is an LLC and you want to invest under a convertible note or a SAFE, the templates are drafted to be for corporations, but you can easily change them. My templates, I have templates for LLCs, and I do lots of notes and SAFE investments. Into LLCs. You just have to— when it finally converts, or when the investment converts, the LLC will also convert into a C corp. You had a question, but I don't know if I—

but for the buyer, one of you guys, they have to be a corp.

What's that?

For it to invest within this due diligence process, they have to basically conversion talk.

I don't know. I'm pretty sure. Yeah, if you're investing, if Estac invests in a convertible note or a SAFE, It's not mandatory that the company be a C corp. It all might be part of the terms.

Yeah.

And they would need to convert for us to the S corp. There might be good reasons to convert it, but it's not mandatory. And I'll just put a plug real quick. There's a weird aspect in California that if you form a C corp as a founder, you're going to be classified as a W-2 employee.. And most founders don't pay themselves. And so, if you have 3 or 5 founders of a startup all who formed a C-Corp and they run the C-Corp for 4 years and none of them pay themselves, they have 4 years of accumulated unpaid wages claims. And when founders dispute and one departs, there's a negotiation. And the founder, the departing founder can often demand 4 years of unpaid wages. Which could be hundreds of thousands of dollars. So there can be a good reason to form an LLC to avoid that problem because there's another weird law that if you're an owner of an LLC taxed as a partnership, you cannot be taxed, you cannot be classified as a W-2 employee when you're a partner of a partnership. So you avoid that problem. There's also an interesting QSBS advantage that you might gain if you form as an LLC. When you form, it's almost zero value. So I mentioned that your exclusion from tax is $15 million or 10x what you paid. So what if you paid a ton? Well, the company at formation is worth close to zero, but if you operate for 2 or 3 years as an LLC, then convert to a corp, the value at the time of the conversion is counted for your basis to calculate 10x what you paid. So there could be a possibility of converting at a higher valuation and increasing your QSBS potential. So those are two reasons why considering an LLC might be a good reason. But again, I'm not an evangelist. I just— my job as an attorney is just kind of lay out the landscape and let people make the right decision. Did we do justice to your question?

Right. Okay. Um, cool question. So converting from an LLC to a C corp, how, what clause do you have to put in place to say that the ent— because they're independent entities, right? That the entity that was defined as an LLC becomes the entity that's defined as a C corp and that carries forward. Like, look, what do you, what do you, because you can call it something else, right? It could be a completely different company.

Um, true. So, um, what, what's the question though?

Well, I, I could, I can start LLC A and then I decide, you know, at a later time I'm gonna call it create a C corp, it's kind of materially maybe the same materials, but it's a new entity. So how do I as an investor guarantee that that entity actually gets carried over from all its warrant— all its liabilities to the C corp? It's all responsibilities. And right.

Cool. So yeah, if you sign a SAFE or convertible note with an LLC, that's a contract between you and that LLC. Let's assume there's no other investors and the founders of this LLC, they want to then convert to a corporation. Under conversion laws, when they convert to a corporation, that new corporate entity under the laws of conversion is the same entity except for its form. So all prior contracts automatically come with it without any further need to amend the contract. All debts, all obligations, all liabilities, everything automatically stays with that company. If those same founders were to form a separate corporation, it would be an entirely different entity. And unless they took all the assets from the LLC and, and transferred them, which would be a sale of assets, uh, so if they wanted to run this business in a separate corporation formed separately, not converting this one but a separate, they'd have to take all the assets of this company and sell those assets to that company. That would be extreme. It would require consents, and it's probably not going to happen. So again, when the LLC converts, your SAFE agreement is going to be with that LLC. And then when it converts, now it's a corp. And then when they do their Series A, you're going to convert into that Series A. Does that make sense or— Yeah, it kind of makes sense. What contractual language has to be in place to protect that from an investor's standpoint? To protect what? To protect the founders from forming a different company? Shoot, let me think about that. Maybe James has a better answer while I'm on the spot. Fiduciary duty. Yeah. I mean, if they form a different entity and they transfer the assets without consent, that could be fraud. Yeah, there's a lot of things already in place to prevent stuff like that from happening. And I should mention also that the fact that the LLC can convert into a corp, it happens regularly. So there are a lot of angel or VC financing deals that are done where the company is an LLC while you're doing the term sheet and you're negotiating the investment, and it is very common for that LLC to convert at the close of the financing. In fact, the term sheets will often say that that's part of the deal. But also, you shouldn't take lightly the fact that there are legal fees involved with converting this entity. Sometimes the legal fees are on the lower side, but if the company is mature and has a lot of contracts, a lot of employees, and other things, there might be a lot of work involved to convert the LLC. And I had an investor tell me once, they're like, the conversion was horrible because it cost $200,000 just to convert the LLC. That's extreme, and it probably had a lot of things going on. So usually the price of conversion is on the lower side and will outweigh the benefits you might have gained from being an LLC. But it's something to take into account. So one of the things—

Regarding, I guess, like the SAFE and convertible note in particular, these have been around for a long time. They've probably been through litigation at some point. They're pretty well traversed. Is there any danger in kind of modifying those core documents just in terms of special terms or addendums to them that become an issue over time? Because I'd imagine these SAFEs and convertible notes have been brought to courts before.

No? Yeah.

Interesting. Oh, just side note, SAFEs didn't really get popular until the pandemic. They were frowned upon mostly before 2020, and they really took off in the last 4 or 5 years to where they're the dominant vehicle. But it's— Y Combinator created in 2013, 2014, and it was really only used by YC and other Silicon Valley. It didn't have a lot of traction outside Silicon Valley.. But now it's super popular. So, when you go on the Y Combinator website where you can download the SAFE, there is a template side letter. And so, you can— there is a process that if you want to add terms, if you want to add complexity to your SAFE investment, there is a process, a templated side letter. It gives you pro rata rights. But you can also add other rights into side letters. And that's fairly common. You probably don't want to mess with the terms of the SAFE much, but I actually— there's a lot of good attorneys who will modify the terms of the SAFE. Neal says no. When I'm representing the company, I will often modify the SAFE. So I mentioned the full ratchet anti-dilution problem. And this could get into the weeds again about calculation of conversion. But there's a defined term in the SAFE called company capitalization. And the more stuff you put into that definition, the more founders can be penalized because it affects the conversion ratio. And so I changed that definition to put a fence around it. That's one change that I make to the SAFE. And then investors, sometimes investors— the SAFE will convert on any future equity financing. Sometimes investors want to put put guardrails on that and they want to say like, has to be a minimum million-dollar financing. So that's a pretty minor change to the SAFE. Convertible notes get changed a lot. And actually, I didn't mention in my slides, but the Angel Capital Association, ACA, they created a model convertible note template that they put on their website. It was fall of 2024. Yeah, 2024. And they add other things that weren't typical. Like, I think they add board rights and information rights and more robust reps and warranties. And then I've heard attorneys say that they don't like, for example, I mentioned this, the Series C preferred stock. It's an alternative to Series A. So Series A, I mentioned NVCA.org, and there's a bunch of law firms who contribute to that effort and creating annotations and constantly updating the documents for latest changes in law. So the NVCA documents are thoroughly vetted regularly, but the Series C documents are not. And so some attorneys don't like to do Series C simply because they don't have that same rigorous vetting that's going on. Constantly with the Series A documents. So that's part of your question is like, you know, the Series C docs are not as heavily used, nor are they litigated as much, if at all. I don't know. So they're just less well known. And then obviously with the new thing that I created, it's brand new in the market. And if there's a huge defect that I created in there, you might be the test subject to find out in litigation about it. So yeah, and same thing with the document that Mintz created, it's brand new, so it's not been around for a long time, so there's unknowns.

Go ahead.

Thank you.

Can you describe the protection of IP in the conversion of LLC to corp? The protection of IP?

Yeah.

Yeah, so when I was, Answering his question, all contracts, all assets, all liabilities that exist with the LLC, they automatically travel over when the entity is converted. It's similar to a merger. In fact, if you form a California LLC and you want to convert into a Delaware C corporation, you can't do the conversion mechanism, you have to do a merger. You have to form a Delaware corporation as a separate entity, which you were asking about, but then you merge the two together. And the merger acts the same way. By contract or by law, everything that was part of the prior entity automatically gets assumed into the new one. So if there's patents, trademarks, copyrights, etc., trade secrets, everything, it all carries over. But then you need to be sure to update the USPTO to reflect the new entity.

Sebastian's here, so if you want to have him comment on the VINS documents.

Oh yeah, that's right, we have an expert in-house, and I know Amit was involved in that.

Yeah, exactly. So we've already mentioned the qualified small business stock issue, and so one of the kind of gray areas out there, and as you know, we attorneys, we hate gray areas, is whether or not a SAFE is eligible for treatment as QSBS. And so that's an open question. And so what we've put together recently at Mintz is something that operates exactly like the SAFE, but is actually stock. And it's kind of complicated and deep, like this is deep in the nerdy, like corporate law weeds, right? But the way it works is it creates a share of stock, but then when there's a subsequent financing, that share magically transforms into the new preferred stock. So it gets you all the functionality of a SAFE, but then really plants a flag deep in the territory saying, yes, this absolutely is QSBS eligible. So I'm sure they'll eventually get around to either interpreting or changing the law such that a SAFE is automatically QSBS eligible, in which case we've done work for nothing. But that's where we currently are.

I think also interesting comment, you might know of this, Sebastian, but Israel has a similar issue. They have SAFEs, they have similar tax laws. I'm not an Israeli tax I'm not an attorney or corporate attorney at all, but they addressed this problem of the SAFEs not really, not totally being deemed to be equity. And so, they made a set of rules in their tax law that SAFEs must comply with in order to be treated as equity. And there's this whole robust set of requirements that SAFE must comply with to be treated as equity.

Must be nice to live in a country with functioning legislation.

Right. So, but it's interesting though, with that same problem, our IRS has not addressed the issue, but it does emphasize how important the issue is. It was so important in Israel that they decided to address it. They wanted to allow safe investment and they wanted to allow the equity treatment, so they made a whole set of rules to come under to create that. So it also signifies there might be a danger under U.S. law that if SAFs are just operating as they are now, that they will fail all of that and the IRS will deem them not qualified for QSBS treatment.

I know you're not a tax attorney, but quick question legally, do you have to file something on a QSBS when the conversion occurs? Is there something that legally either an SPV and/or an individual who's in that SPV or an individual investor?

I'm going to rely on— I'm not a tax attorney. I don't know. I don't know. Just— I think you just claim it on your tax return.

So you don't have to file something at the time of the transaction?

No, I'm not aware of any filing. No, I think you just claim it on your tax return as a gain qualified under QSPS, and then you just see if you get audited. And with the IRS being gutted like it has been recently, there's nobody to audit you. And so what's the chance that you'll get audited in the next 4 years? Probably low. Your advice is to continue with the— Well, I mean, if the company is a stellar company and the deal is safe, it's good to know about all this stuff. But don't pass up a great deal just because there's some flaws. There's always flaws with everything. Every document has flaws. Every document has pros and cons. And SDAC might not be the lead investor. The company might win like $200K from SDAC, but they might be already doing a financing and it's already a SAFE and you don't have the power to change. So—

The odds of us leading are relatively low.

Yeah. Yeah, I think so. Well, I had a client that won and we did a SAFE. I'm the one who drafted it. And SDAC invested in that client with a SAFE. There's good reasons to use a safe. Thank you, Brian. Yeah, thank you.