7 Questions Answered / 4 Recent Answers
September 8, 2023
A: Dispute resolution under a software agreement or other contract will typically be governed by the terms of the contract. A well-prepared software agreement will include a specific section or other provision saying exactly how a dispute will be resolved. These can (and often should) be very detailed. Sometimes, different types of disputes will have different dispute mechanisms.
For example, a dispute over whether a deliverable was accepted may be subject to one approach, a dispute over payment may be governed by another, and a dispute over a claim of a violation of third-party rights by yet a third.
Again, it depends on the terms of the contract. Hopefully, your contract includes a clear and specific provision for dispute resolution. If not, then you would default to trying to work it out. If that is not realistic, if the parties are willing to try mediation, that is often far more preferable to a lawsuit, both because it is usually far less expensive, and because it is not public.
But, mediation is voluntary and, if the parties don't come to an agreement with the assistance of the neutral mediator, there is nothing from the mediation that can be enforced. That leaves the parties with a lawsuit or, if the parties agree (or if the contract provides for it) arbitration might be used instead of a lawsuit. Arbitration is often (but not always) less expensive. But, it will be confidential, whereas a lawsuit is a public matter.
My dispute resolution provisions often include a stepped approach. Before a party is entitled to sue or initiate arbitration, they have to try to work it out between themselves for a specified period of time. Failing that, often I provide that mediation must be the next step. Only after that, if resolution by mediation fails, is arbitration or a lawsuit permitted.
A good dispute resolution provision should include a number of other provisions, including: governing law, location of the proceeding (venue), forum (e.g., federal or state court, or AAA or JAMS as the arbitrator), number of arbitrators if applicable, rules of evidence and other rules in an arbitration if applicable, waiver of procedural defenses to venue and forum, a "loser pays" provision (or not), possibly a cap on "damages" (money the loser must pay), a contract-based statute of limitations, a finality provision (no appeals allowed), how and where an award under arbitration can be enforced ... among other considerations.
Also, in many cases you will want a carefully prepared "equitable remedies" provision that is separate from any other dispute resolution provisions. This would allow a party to go to a court to ask the court not for money, but for force the other party to do or not do something. This often covers things like confidentiality, non-disparagement, indemnification, misuse by one party of property owned by the other, or other situations where payment of money is not applicable or won't be enough.
Finally, these days, it is not a bad idea to include a specific provision allowing remote proceedings during any time and place where governing authorities have declared a health emergency related to a contagion ... or even just where an in-person proceeding can fairly be substituted with technology like Zoom to help keep costs down and otherwise for general convenience of the parties and "judicial economy."
September 8, 2023
A: Good question. Convertible notes (as well as SAFE's, discussed below) differ from equity in several respects. The most fundamental difference is that a convertible note is debt.
A second major difference is that, although the note is debt, its terms include the noteholder's right to acquire an equity position in the future; if a certain event later occurs (defined in the note, but typically the sale of preferred stock to a future investor (e.g. a venture capital firm), but also a sale of the company can have a similar effect), this will trigger the note to convert into equity and the note is "satisfied" ... that is, the debt is extinguished when the note converts and the holder thereby becomes an equity holder (typically coming to own shares of preferred stock very similar to that issued to the future investors in that triggering event).
These two differences are related to a third. A convertible note is often issued without a valuation of the company. For example, when a startup business has no operating history, it is impossible for the startup founders or the investor to decide what the company is worth. Equity cannot be issued for a fair market value (FMV), since there is no basis to determine what the FMV is. A convertible note resolves that by giving the investor (the note holder) the right to convert the note into equity later on, when another investor and the company can agree on a company valuation. In other words, the convertible note allows the company to "kick the can (of valuation) down the road" to be dealt with at another time.
But, since a convertible note is debt, is has a repayment provision, and normally carries interest. This means that the note is carried on the company's balance sheet as debt, and presents the company with the future obligation to repay the note if a conversion event has not happened before the note's maturity date.
So, SAFE's are often used, especially now that they have become so familiar to investors. (SAFE stands for Simple Agreement for Future Equity). Essentially, as SAFE is a convertible note without the debt features. A SAFE carries no interest and does not have to be repaid. The investor in a SAFE will normally be sophisticated and able to assess the chances the company will do well enough for a conversion event (the issuance of preferred stock, or a sale of the company) to result in the investor's SAFE converting, and thus give the investor comfort that would otherwise be lacking in an instrument that has no repayment obligation. Like a convertible note, a SAFE kicks the can of valuation down the road, where a valuation can later be determined by the company and a future investor.
Founders should exercise caution in issuing convertible notes or SAFE's. Among other reasons, founders commonly do not appreciate the impact that convertible notes or SAFE's can have on the founders' own ownership. Convertible notes and SAFE's often include a feature called a "valuation cap." This can result in surprising dilution, as well as the issuance of equity to the converting note or SAFE holder at what is effectively a very low price per share, costing the company far more than the founders may have expected.
Also, notes and SAFE's with very similar, but different, terms can result in a complicated capitalization table, making negotiations with venture capital firms later on more difficult, an equity transaction more complex, and thus the process more time-consuming and (therefore) more expensive.
August 11, 2023
A: Good question! Though, more information would be needed. This seems like something you would want to submit a formal request for bids on. This is square within my practice area, so I'd love to consider assisting you.
Wojcik Law Firm, PC
August 11, 2023
A: Thanks for the interesting question. There may be some conflation of issues here. A few points may help to clarify --
1. A SAFE and a Note are different animals. Notes are debt instruments and, accordingly, usually have an interest component. SAFE's are not debt and so do not accrue interest. Convertible Notes and SAFE's are similar in that they both typically convert into preferred stock when the company **later** issues preferred stock. Also, Convertible Notes and SAFE's are often issued without regard to a company's then-current valuation.
2. You said your company issued SAFEs / Notes "as part of" a Series A funding. That's not legally impossible, of course, but it would be unusual, so it would be helpful to make sure we are using the same "glossary" of terms. Typically, the phrase "Series A funding" refers to a company's issuance of Series A Preferred Stock; such transactions involve putting a value on the company so that the Series A stock can be priced. Series A rounds often are preceded by the company issuing Convertible Notes or SAFE's without a valuation of the company (that is, the company and investors "kick the can down the road" to a later time when the company's operating history can justify a valuation). Then, when the Series A round occurs and shares of Series A are priced based on the company valuation, any pre-existing Convertible Notes and SAFE's convert into shares of Series A preferred stock at a conversion price that is equal to the price paid by the Series A purchasers, minus the discount that the Convertible Notes or SAFE's give to their holders. (NOTE: these days, often there is a round of preferred stock sold BEFORE Series A, called Series Seed. This is not required, but common. Sometimes SAFE's or Notes are issued between Series Seed and Series A, but, again, it would be the odd investor who purchased a SAFE or a Note in the same financing round in which preferred stock is sold.)
3. The implications of SAFE's and notes can be several. One of the biggest is their impact on the company's capitalization table ... that is, on the ownership interests of other shareholders, especially the founders. The terms of each Note or SAFE will determine their impact when they convert, especially if they have a "valuation cap" ... which is a provision by which an effective discount is given to the holder of the SAFE / Note. Valuation caps can result in more dilution to the founders and other pre-existing shareholders than they might expect, depending on the actual valuation of the company when these Convertible Notes and SAFE's do convert.
4. If you issued Convertible Notes or SAFE's as part of a Series A preferred stock round, the investors purchasing the Series A would have to have known about and approved of it. Their lawyers would have certainly raised eyebrows and asked questions. If these Convertible Notes / SAFE's were issued outside of the knowledge of the Series A investors, this would be expected to be problematic for the company, and possibly a breach of the Series A investment documents, or even a violation of certain securities laws. But, if all was approved by the investors, no problem.
5. Another implication worth noting is that since Convertible Notes are debt, they typically would be carried on (shown in) the company's balance sheet. Investors in Series A round always or nearly always have Information Rights to see the company's financial statements and be kept current on changes. Normally the company would have a contractual obligation to provide quarterly, if no monthly, financial reports and updates to Series A investors. These reports should include all information about SAFE's and Notes.
6. It should also be noted that Series A investment documents typically restrict the company from issuing many types of new securities without the approval of what these docs often call the "Requisite Holders." This is a defined term in the Series A investment docs (normally in the company amended and restated Charter), and is defined as the Series A holders that hold at least a stated number (e.g., a majority) of all of the Series A shares sold in the round.
Note that these answers are not and should not be taken as legal advice for your particular situation. You should retain qualified legal counsel to have a formal lawyer-client relationship and your lawyer should review all relevant information. But, these concepts here are pretty fundamental.
Wojcik Law Firm, PC