Mirror Mirror – who’s the most favored nation of them all?
10.07.2019
The "Most Favored Nation" provision, or in simple practitioner jargon - the "MFN", allows the beneficiary of the provision to enjoy the most favorable rights offered in a specific context. If you are wondering about the "Nation" part (we sure did!), turns out that it traces back to late 18th century trade agreements, in which states began negotiating guaranteed continued preferred treatment from their partners in international trade agreements and with time the practice eventually spread to private commerce.
So, imagine Company X negotiates a commercial agreement with Company Y. Although Company X feels that the terms are good enough to close on, it requests that a MFN be included in the agreement. Once included, if Company Y will later negotiate an agreement with Company Z, and such agreement will have terms more favorable than those agreed upon with Company X, Company X will be entitled to the same favorable rights as were granted to Company Z.
Considering the above (and despite what you might have deduced from the word "favored") the MFN actually acts as an equalizer amongst players in a certain context. The MFN ensures that members of a certain group (e.g. members to a trade organization or participants in an investment round) get equal terms and equal treatment.
As corporate and commercial lawyers, we will typically deal with MFNs in the context of certain commercial agreements (such as manufacturing or distribution agreements) or in various investment instruments (such as side letters to VC/PE fund investments or in convertible financing instruments such as SAFEs).
The Challenge
The challenge in the use of an MFN provision, at least in its original form, lies in the assumption that we are comparing apples to apples, and accordingly, that all apples should receive equal treatment. For example - if you intend on charging tax for the importation of goods into your country, and you are part of a certain international trade organization, then it would be a legitimate expectation from the members of such organization that you charge the same tax with respect to the importation of goods from every other country in the group.
But what if we are comparing apples to oranges?
This is something we encounter often when dealing with MFNs in the context of convertible financing instruments such as the SAFE. It looks something like this:
Investor A ("A") gives the Company US$100K in a SAFE, under which it was granted MFN treatment. Three months later investor B ("B") gives the Company US$200K in a SAFE in which he also added some representations regarding the capitalization of the Company and the status of its IP. B also managed to negotiate the right for an observer on the Company’s board. Now A approaches the Company and requests to receive the most beneficial rights granted – i.e. the right to appoint an observer, as well as similar representations which were given to B.
This seems unfair; whilst B had indeed received preferential rights, it is B who has actually risked 100% more than A, so perhaps it is fair that B alone should receive "more". Perhaps apples and oranges should be treated differently.
Some Thoughts
With the above in mind, here are some points to consider when dealing with MFNs in the investment realm.
1. Same money/same risk. To deal with the "apples and oranges" challenge, a common "tweak" to a MFN, would be to limit the application of the MFN solely to the more favorable terms offered to investors of similar or smaller scope than the investor receiving the MFN status. This way, companies still have the freedom to offer a better deal in order to land the larger investor, without having to undertake the inevitable economic hit that would result from having all its smaller investors match those terms. This is also the cleanest way to delineate what constitutes an apple and when we shift to oranges, as in the example above. Investor B invested significantly more than A, and it is therefore reasonable for B to get better terms, despite A taking the early risk. Limiting A’s MFN to future agreements the company makes for investments of the same or lesser amounts protects A from getting short-changed, but only to the extent the newer investor has the same (or less) at stake.
2. (No) Cherry picking. When dealing with MFNs, the question arises of whether or not cherry picking should be allowed, i.e. should the MFN holder be allowed to pick those beneficial rights granted to a later investor and ignore those parts of the later investor’s agreement which it is not interested in, or is it a "package deal" - if you want the beneficial rights; you need to accept the entire agreement. Without taking a firm stand on this point, it is noteworthy to mention that Y-combinator’s sample SAFE with an MFN provision does not allow for cherry picking by conditioning the exercise of the MFN on the amendment of the original SAFE and the adoption of the subsequent agreement as a whole. This certainly has logic to it, after all, agreements are negotiated as a whole.
3. But maybe not. On the other hand, in the SAFE context (at least when used in pre-seed/seed capital financings) there is perhaps merit to the argument that an earlier investor should receive the better terms that a later investor (in the same SAFE round) received, even if the later investor invests a larger sum in the company. Companies are currently using SAFEs to raise initial capital and keeping such rounds open for longer periods of time. A SAFE investor in the earlier stages of the round is taking significantly more risk than a SAFE investor coming in 12-18 months later. The passage of even small periods of time can be significant when assessing a start-up. The investment decision of the later SAFE investor is based on better data and better facts – data/facts which were created based on, amongst others, the early SAFE investors’ money. It is therefore not unreasonable to consider that the early SAFE holder with a MFN should receive the beneficial rights of a later SAFE holder, even if such later holder invests greater amounts, without necessarily insisting that the early SAFE holder also be confined to the surrounding terms. Maybe the initial SAFE holder should be allowed to pick and choose from better terms offered to future investors as a reward for its earlier "blind" investment.
4. Discount/Caps/Qualified Round. Irrespective of how you feel about cherry picking, in the event a later investor in the SAFE round receives a better discount/lower cap, there is merit to the argument that the earlier SAFE investors should receive the same discount/cap, irrespective of their investment amount. In the SAFE context, the discount and cap serve as sort of an equivalent to the valuation factor of a regular equity round, which is the key factor in any investment. The discount/cap are the SAFE investor’s insurance policy that despite the tremendous risk it is undertaking it will be getting a better price. In this context, and vis-à-vis the earlier SAFE investors, a later SAFE investor with a better discount/lower cap is somewhat equivalent to a "down round" in regular equity round terms. Similar to the cherry-picking situation, one can argue that the early SAFE investor should be entitled to such better terms, as a "payoff" for its earlier "blind" investment (similar to anti-dilution rights). Another way to look at it is as follows: consider an equity round with an initial closing and which allows for one or more deferred closings. Now imagine the company lowers the valuation for a certain investor in the deferred closing…we doubt that would fly too well.
Full disclosure – the views herein merely represent some thoughts of the authors. Spero Levi & Co. looks to maximize our client’s position, which varies depending on whether we are the investing or receiving side. That said – Spero Levi & Co. are big believers in fair-market solutions and try to advise our clients to act accordingly.
So, imagine Company X negotiates a commercial agreement with Company Y. Although Company X feels that the terms are good enough to close on, it requests that a MFN be included in the agreement. Once included, if Company Y will later negotiate an agreement with Company Z, and such agreement will have terms more favorable than those agreed upon with Company X, Company X will be entitled to the same favorable rights as were granted to Company Z.
Considering the above (and despite what you might have deduced from the word "favored") the MFN actually acts as an equalizer amongst players in a certain context. The MFN ensures that members of a certain group (e.g. members to a trade organization or participants in an investment round) get equal terms and equal treatment.
As corporate and commercial lawyers, we will typically deal with MFNs in the context of certain commercial agreements (such as manufacturing or distribution agreements) or in various investment instruments (such as side letters to VC/PE fund investments or in convertible financing instruments such as SAFEs).
The Challenge
The challenge in the use of an MFN provision, at least in its original form, lies in the assumption that we are comparing apples to apples, and accordingly, that all apples should receive equal treatment. For example - if you intend on charging tax for the importation of goods into your country, and you are part of a certain international trade organization, then it would be a legitimate expectation from the members of such organization that you charge the same tax with respect to the importation of goods from every other country in the group.
But what if we are comparing apples to oranges?
This is something we encounter often when dealing with MFNs in the context of convertible financing instruments such as the SAFE. It looks something like this:
Investor A ("A") gives the Company US$100K in a SAFE, under which it was granted MFN treatment. Three months later investor B ("B") gives the Company US$200K in a SAFE in which he also added some representations regarding the capitalization of the Company and the status of its IP. B also managed to negotiate the right for an observer on the Company’s board. Now A approaches the Company and requests to receive the most beneficial rights granted – i.e. the right to appoint an observer, as well as similar representations which were given to B.
This seems unfair; whilst B had indeed received preferential rights, it is B who has actually risked 100% more than A, so perhaps it is fair that B alone should receive "more". Perhaps apples and oranges should be treated differently.
Some Thoughts
With the above in mind, here are some points to consider when dealing with MFNs in the investment realm.
1. Same money/same risk. To deal with the "apples and oranges" challenge, a common "tweak" to a MFN, would be to limit the application of the MFN solely to the more favorable terms offered to investors of similar or smaller scope than the investor receiving the MFN status. This way, companies still have the freedom to offer a better deal in order to land the larger investor, without having to undertake the inevitable economic hit that would result from having all its smaller investors match those terms. This is also the cleanest way to delineate what constitutes an apple and when we shift to oranges, as in the example above. Investor B invested significantly more than A, and it is therefore reasonable for B to get better terms, despite A taking the early risk. Limiting A’s MFN to future agreements the company makes for investments of the same or lesser amounts protects A from getting short-changed, but only to the extent the newer investor has the same (or less) at stake.
2. (No) Cherry picking. When dealing with MFNs, the question arises of whether or not cherry picking should be allowed, i.e. should the MFN holder be allowed to pick those beneficial rights granted to a later investor and ignore those parts of the later investor’s agreement which it is not interested in, or is it a "package deal" - if you want the beneficial rights; you need to accept the entire agreement. Without taking a firm stand on this point, it is noteworthy to mention that Y-combinator’s sample SAFE with an MFN provision does not allow for cherry picking by conditioning the exercise of the MFN on the amendment of the original SAFE and the adoption of the subsequent agreement as a whole. This certainly has logic to it, after all, agreements are negotiated as a whole.
3. But maybe not. On the other hand, in the SAFE context (at least when used in pre-seed/seed capital financings) there is perhaps merit to the argument that an earlier investor should receive the better terms that a later investor (in the same SAFE round) received, even if the later investor invests a larger sum in the company. Companies are currently using SAFEs to raise initial capital and keeping such rounds open for longer periods of time. A SAFE investor in the earlier stages of the round is taking significantly more risk than a SAFE investor coming in 12-18 months later. The passage of even small periods of time can be significant when assessing a start-up. The investment decision of the later SAFE investor is based on better data and better facts – data/facts which were created based on, amongst others, the early SAFE investors’ money. It is therefore not unreasonable to consider that the early SAFE holder with a MFN should receive the beneficial rights of a later SAFE holder, even if such later holder invests greater amounts, without necessarily insisting that the early SAFE holder also be confined to the surrounding terms. Maybe the initial SAFE holder should be allowed to pick and choose from better terms offered to future investors as a reward for its earlier "blind" investment.
4. Discount/Caps/Qualified Round. Irrespective of how you feel about cherry picking, in the event a later investor in the SAFE round receives a better discount/lower cap, there is merit to the argument that the earlier SAFE investors should receive the same discount/cap, irrespective of their investment amount. In the SAFE context, the discount and cap serve as sort of an equivalent to the valuation factor of a regular equity round, which is the key factor in any investment. The discount/cap are the SAFE investor’s insurance policy that despite the tremendous risk it is undertaking it will be getting a better price. In this context, and vis-à-vis the earlier SAFE investors, a later SAFE investor with a better discount/lower cap is somewhat equivalent to a "down round" in regular equity round terms. Similar to the cherry-picking situation, one can argue that the early SAFE investor should be entitled to such better terms, as a "payoff" for its earlier "blind" investment (similar to anti-dilution rights). Another way to look at it is as follows: consider an equity round with an initial closing and which allows for one or more deferred closings. Now imagine the company lowers the valuation for a certain investor in the deferred closing…we doubt that would fly too well.
Full disclosure – the views herein merely represent some thoughts of the authors. Spero Levi & Co. looks to maximize our client’s position, which varies depending on whether we are the investing or receiving side. That said – Spero Levi & Co. are big believers in fair-market solutions and try to advise our clients to act accordingly.
