Following up on the previous article, where we began discussing Early Stage funding rounds, it is worth examining what we consider to be the most interesting format for making Early Stage investments in current times, the Advance Investment Agreement, also known by other names such as Advance Equity Agreement or Advance Subscription Agreement.
Before proceeding, it is worth noting that in some cases, there is justification for conducting an initial Seed round through equity issuance, thereby gaining two significant advantages: first, when the round involves selling common shares to investors rather than preferred shares (Preferred Shares), and second, it provides an excellent opportunity for the founders to adopt a company’s Articles of Association (which is the most crucial document for the company and its founders) according to their own vision, rather than one dictated by investors.
(A serious Articles of Association document is typically dozens of pages long, and its drafting cost is generally not low—therefore, it is worthwhile to handle this within a sizable investment round).
In other words, adopting a high-quality Articles of Association at an early stage prevents investors from dictating its terms later when a more comprehensive version is required (typically from Series A onwards), thereby laying the groundwork for a more focused negotiation on specific investor rights in future rounds rather than on the entire document.
However, in some cases, reducing costs and raising funds quickly is preferable, leading us to the discussion of Convertibles, which are convertible securities—financing that, under certain conditions, transforms into company shares.
As previously discussed in our last post, the Advance Investment Agreement is, in our opinion, the clear winner. The Advance Investment Agreement format offers several advantages over its competitors in the category, which we will explore further.
The primary comparison is always between the Advance Investment Agreement and the SAFE. It is important to understand that, unlike SAFE, which is a ready-made template available for download from Y Combinator (intended for minimal modifications), the Advance Investment Agreement is a lawyer-driven format, similar to any other investment agreement, meaning it allows for more drafting flexibility and does not follow a universal template.
Conversion Events in Convertibles
This post will focus solely on conversion clauses, as they are the most crucial aspect of Convertible agreements. A conversion event is an event in which, under predefined conditions, the investment amount is converted into company shares.
The Advance Investment Agreement typically includes several key conversion events, and as legal practitioners, we generally incorporate the following:
Automatic Conversion in a Qualified Financing Round
A Qualified Financing Round is a round above a certain investment threshold and, in some cases, one in which shares of a specific type are issued (usually preferred shares).
For example, under the SAFE framework, a Qualified Round only includes financing rounds in which preferred shares are issued. This is a significant disadvantage for the company because if it raises capital in the next round by selling common shares, the investment will not be automatically converted.
The definition of a Qualified Round in SAFE is as follows:
"Equity Financing. If there is an Equity Financing before the termination of this Safe, on the initial closing of such Equity Financing, this Safe will automatically convert into the number of shares of Safe Preferred Stock equal to the Purchase Amount divided by the Conversion Price.
In connection with the automatic conversion of this Safe into shares of Safe Preferred Stock, the Investor will execute and deliver to the Company all of the transaction documents related to the Equity Financing; provided, that such documents are the same documents to be entered into with the purchasers of Standard Preferred Stock, with appropriate variations for the Safe Preferred Stock if applicable, and provided further, that such documents have customary exceptions to any drag-along applicable to the Investor, including, without limitation, limited representations and warranties and limited liability and indemnification obligations on the part of the Investor."
In contrast, in Advance Investment Agreements, we typically define a Qualified Round based on the investment amount rather than the type of share issued. This means that conversion will also occur if the company raises a substantial amount by selling common shares.
For example, in one of our recent transactions, the definition of a Qualified Round in the Advance Investment Agreement was:
"Issuance upon Qualified Financing. In the event of the consummation by the Company of a transaction or series of related transactions in which the Company issues securities, in consideration for an aggregate investment of at least US$ 1,000,000 (one million United States Dollars) (excluding the Investment Amount) (a “Qualified Financing”), the outstanding Investment Amount shall automatically convert into such number of shares issued in such Qualified Financing, as is obtained by dividing the outstanding balance of the Investment Amount as of the closing date of the Qualified Financing by a price per share which shall reflect a twenty percent (20%) discount off the lowest price per share paid in the Qualified Financing."
Here, we see that a Qualified Round is any round in which the company sells shares totaling at least $1 million, regardless of the type of shares issued. This benefited the company by allowing it to convert the investment into common shares in a future round, which was indeed the case.
This is a clear advantage over SAFE. While it is technically possible to modify this term in a SAFE agreement, its predefined template establishes a market standard, making deviations more challenging to negotiate.
Conversion in a Non-Qualified Round
A Non-Qualified Round refers to any financing round that does not meet the Qualified Financing criteria. In this case, similar to other Convertibles, the investment is converted at the investor’s discretion into shares issued in the round.
Investor Demand Conversion (At-Will Conversion)
Another conversion event is one where the investor has the right to demand conversion at will.
This feature is lacking in SAFE. The absence of this clause means that investors can become trapped if the company does not raise another round after the one in which they originally invested.
An At-Will Conversion Clause in a recent Advance Investment Agreement looked as follows:
"Issuance upon an election of the Investor. To the extent that neither a Qualified Financing, an M&A Event, or an IPO is consummated within twelve (12) months following the date hereof, the Investor shall have the right, but not the obligation, at any time, upon providing the Company with written notice, to cause the conversion of the then outstanding Investment Amount into shares of:
(i) the most senior class of shares of the Company existing at the time of conversion (i.e., the class with first priority rights to distributions over all other classes of shares) (the “Senior Shares”), at a price per share equal to the quotient obtained by dividing (A) the company valuation of two and a half million United States Dollars (US$ 2,500,000) by (B) the issued and outstanding share capital of the Company, on a Fully Diluted Basis as of the date of the notice (the “Senior Shares Price”)."
Conversion in an Exit or IPO Event
The final standard conversion event for all Convertibles is conversion at the time of an exit or IPO.
A conversion clause in an Advance Investment Agreement from a recent transaction looked as follows:
"Issuance upon an Exit Event. Unless previously converted or repaid, in the event of the consummation of an M&A Event or an IPO, then, at the election of the Investor (i) immediately prior to the closing of the M&A Event or the IPO, as applicable, the entire outstanding Investment Amount shall be automatically converted into Senior Shares at a price per share equal to Senior Shares Price, or (ii) the Investor shall be entitled to a cash repayment equal to three hundred percent (300%) of the Investment Amount, provided by the Investor to the Company under this Agreement."
Conclusion
The Advance Investment Agreement includes multiple conversion events, similar to a Convertible Loan Agreement, but without the debt component or interest (as discussed in the previous post).
In practice, it retains the benefits of the SAFE while allowing greater flexibility and negotiation room, all while keeping transaction costs low.
For these reasons, in the absence of a Share Purchase Agreement-based investment round, this format is the preferred choice for many lawyers and founders.
