Most Favored Nation or MFN is a term originating from the international trade lingo, that has been in use for hundreds of years. It is also one of the founding principles of the World Trade Organization (WTO).
MFN provision in a trade agreement refers to an extension of the same trade terms to all trading partners. As such, MFN is basically a non-discriminatory trade policy that ensures all the partners in trade get the same treatment.
Similarly, MFN clauses in contracts for products and services prevent sellers from offering said products and services to the buyer’s competitors for a lower price or on better terms.
MFN clauses are also an important element of investment agreements between early-stage startup founders and venture capital firms or angel investors, and that particular subset of the MFN treatment will be the subject of this article.
Table of contents:
- What does MFN mean in investing?
- Investor agreements: SAFE vs Convertible Notes
- How an MFN clause works
- Reasons for using an MFN clause
- Pros and cons of MFN clauses
What does the Most Favored Nation clause mean in investing?
Most Favored Nation (MFN) clause in investing is an important provision included in the investor agreements like SAFEs and convertible notes. MFN clause ensures that the investor receives the same terms as the best deal offered to any other investor in the future. In other words, if the startup signs a subsequent SAFE agreement with more favorable terms, the investor with the MFN clause will automatically receive those same terms.
An MFN clause is typically included in the SAFE agreement itself, and can be triggered if the company offers more favorable terms to a future investor.
What is a SAFE?
A SAFE (Simple Agreement for Future Equity) is a type of investment agreement commonly used in startup financing. It was created by Y-Combinator as a simpler alternative to convertible debt. It is a straightforward and flexible way for founders to raise money from investors without giving up equity in their company upfront. Instead, the investors receive the right to receive preferred stock in the company at a later date, without interest rate. When the company goes public, is acquired, or completes a new financing round, SAFE holder can either get his money back or convert SAFE to common stock.
SAFEs are often used in conjunction with convertible notes as a way to provide flexibility and simplicity in the financing process for both founders and investors.
Want to know more? Find out what startup founders should know about SAFEs before you raise money from investors.
What is a Convertible Note?
A convertible note is a type of debt financing that allows the borrower to convert the loan into equity at a later date, typically when the company raises additional capital. This type of financing is often used by early-stage startups and other companies that do not have a track record of profitability or a well-established valuation.
The terms of a convertible note, such as the conversion price and maturity date, are typically negotiated between the borrower and the lender. The advantage of a convertible note for the borrower is that it provides a way to raise capital without having to immediately agree on a valuation for the company. For the lender, the advantage is the potential to convert the loan into equity in the company at a potentially higher valuation in the future.
Note: The MFN provision is commonly found on uncapped convertible notes as a compromise between the company's desire not to cap the note and the investor's fear that a capped note may be issued in the future.
Learn more about convertible notes and how they work and what are the key differences between SAFEs and convertible notes.
How an MFN clause works in SAFEs
The MFN clause is typically used to protect the investor’s interest in the valuation cap, which is the maximum valuation of the company at which the investor’s SAFE will convert to equity.
For example, startup signs a SAFE agreement with an investor, and the valuation cap is set at $10 million. If the startup subsequently signs a SAFE agreement with another investor, and the valuation cap for that investor is set at $8 million, the first investor with the MFN clause will automatically receive the same $8 million valuation cap.
The MFN clause can also be used to protect the investor’s interest in the discount rate, which is the percentage by which the investor’s SAFE will convert at a valuation below the cap.
For example, let’s say that a startup signs a SAFE agreement with an investor, and the discount rate is set at 20%. If the startup subsequently signs a SAFE agreement with another investor, and the discount rate for that investor is set at 25%, the first investor with the MFN clause will automatically receive the same 25% discount rate.
Reasons for using an MFN clause
So in what circumstances would a startup grant an MFN clause to an investor investing using a SAFE?
A startup might grant an MFN clause to a startup investor investing using a SAFE (Simple Agreement for Future Equity) in order to provide the investor with the same favorable terms that the company might offer to future investors in a future equity round.
This can help to ensure that the original investor does not miss out on any potential benefits that might be offered to later investors, and can help to align the interests of the company and the investor.
Another reason for using an MFN clause is to attract investors. Startups that are seeking funding in difficult market conditions and global economic turmoil can use MFN clause to get investors on board and push the deal over the finish line.
It’s worth noting that MFN clauses are usually done in pre-seed rounds when a company’s valuation isn’t determined yet. It’s not uncommon for your first investor check to be accompanied by an MFN clause.
Pros and cons of MFN clauses
Let’s face it, MFN clauses were designed as protective provisions for investors, hence they’re advantageous for investors and a little less advantageous for founders. MFN protects the interest of investors and ensures that the terms of their agreement will always be at least just as good as anyone who joins the company’s cap table later on.
As far as founders are concerned, MFN clauses can be detrimental to the company’s future.
For example, if the startup is able to negotiate a lower valuation cap or a higher discount rate with a subsequent investor, the first investor with the MFN clause will automatically receive those same terms, which could be less favorable for the company.
What that means is that depending on the terms of a potential liquidity event and the presence of MFN provision in the investment agreements, a startup may have to give up way more equity than it intended to.
The MFN clause is an important provision in convertible securities agreements that can protect the investor’s interest in the valuation cap and discount rate.
While it can limit the startup’s ability to negotiate more favorable terms with future investors, it can also provide investors with some security and assurance that they will receive the best possible terms in the future.