Imagine you purchase a brand-new car and then discover it on sale at the same retailer at a steep discount the very next day – an MFN clause can protect you from this type of scenario when it comes to investing.
What is the Most Favored Nation clause?
A Most Favored Nation clause, or MFN clause as it is commonly known, protects an investor by giving them the same rights and benefits received by later investors, if those rights and benefits are more favorable than those originally agreed.
The primary purpose of an MFN clause in an investment agreement is to give investors comfort that they will not be disadvantaged compared to other investors in subsequent rounds, thus maximizing their potential returns.
MFN clause in a SAFE or Convertible Note
A convertible note or a SAFE (Simple Agreement for Future Equity) are common ways to invest in startups (you can learn more about these agreements here in the Propel(x) blog post SAFE vs. Convertible Note: What’s the difference). An example of an MFN clause in a SAFE can be found in the Y-Combinator SAFE template (accessible here). A screenshot of the MFN clause from the standard Y-Combinator SAFE is shown below:
The key elements of this example clause are If the Company issues any Subsequent Convertible Securities with terms more favorable than those of this Safe… and …the Investor determines that the terms of the Subsequent Convertible Securities are preferable to the terms of this instrument. This wording means the investor is entitled to receive the same terms of any subsequent investment agreement if the subsequent terms are more favorable. In the context of an MFN clause, the most important parameters in convertible notes and SAFEs are:
- Valuation Cap – the set maximum price at which a convertible note or SAFE converts to equity.
- Discount Rate – the discounted price at which a convertible note or SAFE converts to equity, relative to the price paid by investors in an equity priced round.
- Interest Rate – the rate of interest payable on the principal amount of a convertible note (not applicable to a SAFE).
Background of Most Favored Nation status
The term MFN originates from international trade, where a trade treaty or agreement between countries may include a provision entitling one country (nation) to the same favorable trade terms offered to any other country.
Purpose of MFN
An MFN clause can be used in a wide range of contracts and commercial arrangements (not just investing). It could be as simple as a best-price agreement between a wholesaler and a retailer, ensuring that the wholesaler will not supply their goods to a different retailer at a lower price. The primary purpose of an MFN clause in an investment agreement is to give investors comfort that they will not be disadvantaged compared to other investors in subsequent rounds, thus maximizing their potential returns. While MFN clauses have a long history and are extensively used, not all investors are aware of them, and they are often not included in a term sheet. If an MFN clause is not included in an initial term sheet, investors can ask for an MFN clause to be included – this may or may not be successful, but it is certainly a negotiation point worth considering.
How an MFN clause works
An example showing how an MFN clause could work in a SAFE is illustrated below:
- A Series Seed round investor provides capital to a startup via a SAFE that contains an MFN clause, with a $5m Valuation Cap and a 15% Discount Rate.
- A later investor subsequently invests via a SAFE, but manages to negotiate more favorable terms, being a lower Valuation Cap of $4m and a higher Discount Rate of 25%.
- Because of the MFN clause in the Series Seed investor’s SAFE, the company notifies the early investor of the more favorable terms in the most recently issued SAFE and agrees to modify the original SAFE to match the terms of the new SAFE.
- The resultant effect of the original investor’s new SAFE is an increased amount of equity if the SAFE converts and there is a liquidity event.
How to review an MFN clause in an agreement
MFN clauses in investment agreements are prepared and managed by the lawyers handling the investment round. In a SAFE or convertible note, the MFN clause can often be relatively simple, such as in the Y-Combinator example shown above. You could have the relevant clause reviewed by your own lawyer, or you could leverage the experience and expertise of a certified broker dealer such as Propel(x) if they are handling the investment round.
Examples of MFN clauses
As noted above, an MFN clause could be present in a range of different agreements such as those for supply, sales, employment, real estate, lending, media, and more. In an investing scenario, the MFN clause is most commonly present in a SAFE or a convertible note, as outlined above.
Advantages and disadvantages of MFN clauses
The advantage of an MFN clause in an investment agreement is that it favors the investor by allowing them to access the same terms and conditions that might apply to future rounds of capital raising. When an MFN clause is present, it assures the investor that someone else will not be entitled to a better deal and that they will be treated fairly in a liquidity event. MFN clauses can be useful for companies seeking to raise capital in a difficult market, because a MFN clause is attractive to investors. However, MFN clauses can be problematic for companies because it means if they need to offer better terms to entice a later investor, then they also need to provide those terms to existing investors. Depending on the specific conditions of a liquidity event, this may require the company to give up significantly more equity than originally planned. Additionally, the newer investors may be reluctant to share their more favorable terms with earlier investors who hold the MFN clause.
The trend of MFN clauses in investment offers depends on whether the investment landscape is in a seller’s market or a buyer’s market. A startup looking for funding may consider MFN clauses if they are struggling to raise funds. However, if a startup can attract funding without the sweetener of an MFN clause, then it is unlikely they would include one in their funding offer.
An MFN clause provides investors with significant advantages in an investment round, which can have considerable positive impact on returns in a liquidity event. It is therefore important to understand MFN clauses and how they work.
As with any investment, past performance is no guarantee of future performance, and any investment decision must balance the risk against the potential return.