Updated AIC Open Source Seed Financing Documents – what’s changed?

The AIC Open Source Seed Financing Documents are designed to be used as a starting point for seed stage venture investments. The updated suite of templates includes, amongst other documents, a Shareholders Deed (formerly Shareholders Agreement), Subscription Agreement, a Simple Agreement for Future Equity (also known as a “SAFE”) and a SAFE Side Letter. 

The 2023 update has introduced significant drafting changes to the previous suite of documents to reflect changes in the market practice for how seed funding rounds are negotiated and positions that are now commonly adopted. Although it is very difficult to reach an industry consensus on these documents (and hat tip to K&L Gates who have sought to balance competing viewpoints admirably), and opinions will inevitably differ about whether certain of the changes are appropriate, it is important for startups and investors to be aware of the key changes to these templates.

1. Shareholders Deed

Founder director appointment rights – The founder director appointment rights in the updated shareholders deed (“New SHD”) are now individual (i.e. each founder has the right to appoint and replace a director), as opposed to collective (i.e. the founders together have the right to appoint and replace a director). Noting that a founder often only has its director appointment right whilst it is employed or engaged by the company, founder teams should be aware that if a founder leaves, this may change the balance of voting power at the board, either at that time or with the appointment of additional investor nominated directors in future funding rounds.

Bad Leaver – The definition of “Bad Leaver” has been updated to clarify that a founder will not be a bad leaver if the founder’s employment is terminated by the company due to poor performance or alleged poor performance. For founders, this is an important clarification, as the consequence of being a bad leaver is that the founder’s vested shares can be bought back by the company for a discount to fair market value (the New SHD suggests 50% of fair market value) and allegations of poor performance are potentially subjective and, at worst, liable to be misused.

Critical Business Matters – The New SHD includes a more extensive list of matters that are subject to a special board or shareholder approval threshold. A drafting note does state that “these matters should be tailored as appropriate for the business” and founders and investors alike should be careful to not use this list as applicable to every company – both groups will want to strike a balance between appropriate oversight on the one hand and autonomy for the company to conduct its business in the ordinary course on the other. Founders should also be aware that the New SHD suggests that the special shareholder approval threshold should be a certain percentage of the seed preference shares – founders usually hold ordinary shares, and therefore would not be included in this approval threshold.

Pre-emptive rights on an issue of securities limited to Major Shareholders – The New SHD suggests that it may be appropriate that only “Major Shareholders” (i.e. shareholders holding a certain percentage of the shares in the Company) have the benefit of pre-emptive rights on new issues of securities. This is consistent with market practice in the United States, but has been less common in Australia. It could be contentious for smaller shareholders, as it will prevent them from maintaining their percentage shareholding and avoiding dilution by further investing in the company, at least without the consent of the board and/or the Major Shareholders.

Information rights – The New SHD provides shareholders with nearly unfettered access to the books and records of the company (including the ability to have copies) – the only qualification is that such information must be “reasonably required by that shareholder”. Companies may want to consider adding further qualifications (e.g. the company is not obliged to disclose trade secrets, privileged information, etc.), limiting this right to a right of inspection without the ability to take copies, or to remove it altogether and provide shareholders only with agreed regular reports and compliance related information.

References to shares are now on an ‘as-converted basis’ – In the New SHD, all references to shares are interpreted on the basis that all shares capable of conversion have converted into ordinary shares. This change takes into account any adjustments to the conversion ratio of convertible shares (for example by operation of anti-dilution protection on a down-round) when calculating a percentage or respective portion of shareholding.

Power of Attorney clause – The New SHD contains a new power of attorney clause pursuant to which each shareholder appoints each of the company’s directors as its attorney to perform its obligations in respect of any of the transactions contemplated by the New SHD to the extent that the shareholder fails to do so. This is an important change, as it ensures that shareholders cannot seek to circumvent or disrupt the operation of (amongst other things) the drag-along clause by refusing to sign the requisite documentation.

Founder lock-up – The New SHD includes an optional clause for founder lock-up to prohibit a founder shareholder from selling their shares for a certain period of time.

2. Subscription Agreement

Founder and business warranties – In the previous version of the subscription agreement (“Old SA”), the founders were jointly and severally liable with each other and the company for one set of warranties related to the company and its business. The updated subscription agreement (“New SA”) requires that only the company provides warranties in relation to itself and its business (which are more extensive than in the Old SA), whilst each founder gives limited warranties about themselves on a several basis.

Additional limitations on liability – The Old SA only limited the liability of the company and founders to a maximum aggregate amount. The New SA contains additional limitations and exclusions of liability for the benefit of the company and its founders for breaches of warranty, including an exclusion of consequential loss.

3. SAFE

Post-money vs pre-money – The updated SAFE (“New SAFE”) is drafted on a ‘post-money’ basis, whilst the previous version (“Old SAFE”) was on a ‘pre-money’ basis. If the New SAFE converts at the valuation cap, to determine the conversion price the company capitalisation includes, amongst other things, the SAFE itself, all other SAFEs and any other convertible notes on issue. This is in contrast to the Old SAFE, where the SAFE itself, all other SAFEs and any other convertible notes were excluded from this calculation. As a result, the New SAFE will naturally result in a lower conversion price when converted at the valuation cap, meaning that it is more dilutionary for existing shareholders.

Definition of Discount Rate – The New SAFE has made an important drafting change to the definition of “Discount Rate” so that where the discount price applies on conversion, the relevant formula is calculated by multiplying the inverse of the discount percentage detailed in the SAFE (“1 minus” the discount percentage). Although the underlying calculation does not change, this prevents a common mistake made by people using the Old SAFE who were unfamiliar with it, where the intended discount of say 20% was inserted in the schedule instead of 80%, which would result in the Discount Price being calculated as the price per share of the Qualifying Financing multiplied by 20%.

Repayment on insolvency and dissolution events – The New SAFE has been updated to ensure that it is treated as preferred equity in the event of insolvency. This reflects a preference of some local VCs that the SAFE not be treated as debt, and means that, in an insolvency scenario, the New SAFE sits behind any unsecured creditor claims and convertible notes that are treated as debt in the event of insolvency, equally with other SAFEs, and senior to shareholders, whilst the Old SAFE ranked equally with unsecured creditors (and the drafting for treatment as debt is included as a footnote for parties who wish to adopt that position).

4. SAFE Side Letter

The SAFE side letter is a new addition to the AIC templates that is designed as a companion to the SAFE. A company may choose to enter into the side letter with select investors to grant those investors additional rights during the period in which the SAFE is outstanding. Notably, the side letter contains a “Most Favoured Nation” clause and a pre-emptive rights clause.

Under a “Most Favoured Nation” clause, if the company later issues more SAFEs on terms that are more advantageous to the new investor (such as a lower valuation cap and/or a higher discount rate), the existing SAFE holder has the right to amend its SAFE to reflect the better terms of the later issued SAFE.

The pre-emptive rights clause grants to the investor pro-rata rights to participate in any qualifying financing (similar to pre-emptive rights that may have been granted to existing shareholders) that the investor would otherwise not be entitled to given that the investor may not be a shareholder during the period of the SAFE. Importantly, the side letter is drafted so that the pre-emptive rights in the side letter rank behind the pre-emptive rights of existing shareholders, in order to avoid a potential conflict of rights.

If you have any questions about what these changes mean for your start-up or investing approach, please contact our Corporate Advisory team.

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