Foreign investment in the U.S. market, particularly in high-growth technology companies, often begins with the formation of a Delaware corporation. This is a common choice for U.S. startups seeking capital, primarily due to Delaware’s mature, predictable, and investor-friendly corporate law.

For an investor (the “Investor”) investing in a Delaware corporation (the “Company”), the choice of investment instrument depends largely on the Company’s stage and valuation certainty. We can classify the options into two main categories: (A) instruments used before a formal valuation (pre-money), and (B) instruments used in a priced financing round (priced equity).

A. Pre-Money Instruments

These instruments are common in early-stage deals where the parties agree to defer the valuation until a later, more significant funding round.

1. SAFE (Simple Agreement for Future Equity)

A SAFE is a contractual right, not debt, where the Investor provides capital now in exchange for the right to purchase the Company’s preferred stock in a future, priced financing round (e.g., a Series A financing). Unlike convertible debt, a SAFE has no interest rate and no maturity date, meaning it places no immediate debt liability on the Company’s balance sheet.

The SAFE’s conversion into preferred stock is triggered automatically during the Company’s next significant equity financing. The SAFE includes mechanisms to protect the early Investor’s valuation, such as:

• Valuation Cap: This sets a ceiling on the Company’s valuation used for conversion. If the subsequent financing round is priced above this cap, the SAFE converts at the lower cap price, ensuring the Investor secures a minimum equity stake regardless of the Company’s subsequent rapid growth.
• Discount Rate: This is a percentage discount applied to the price per share paid by the new investors in the future financing. The Investor benefits by converting at the lower of the cap price or the discounted price, rewarding them for the Investor’s early risk.

2. Convertible Promissory Note (Convertible Debt)

This is a traditional debt instrument that converts into equity if one or more specified events occur.

• Key Terms: Unlike a SAFE, a convertible promissory note typically has an interest rate and a maturity date. The Investor and the Company negotiate the interest rate and the schedule for repayment/conversion.
• Conversion Risk: If the Company does not meet the specified event(s) by the maturity date, the note typically grants the Investor the right to demand immediate cash repayment of the principal and accrued interest.

B. Priced Equity Instruments

These instruments are typically used when a fair market valuation of the Company has been established, typically in Series A and later financing rounds.

1. Common Stock

The Company’s common stock is the simplest form of equity and is typically held by founders and employees.

• Rights: Holders have basic voting rights and a right to their proportional share of assets upon liquidation of the Company only after all creditors and preferred stockholders of the Company have been paid.
• Suitability: Rarely used by institutional or strategic third-party Investors due to the lack of preferential rights.

2. Preferred Stock

The Company’s preferred stock is the typical investment instrument for a sophisticated Investor and offers superior rights compared to the Company’s common stock.

• Liquidation Preference: Upon a sale or dissolution of the Company, preferred stockholders are paid their investment back, plus any accrued dividends, before the Company’s common stockholders receive anything.
• Protective Provisions: Grant the Investor special veto rights over the Company’s important corporate actions (e.g., selling the Company, issuing more preferred stock, changing the Company’s bylaws).
• Anti-Dilution Rights: Protect the Investor’s ownership percentage from being diluted by subsequent equity issuances at lower valuations.
• Board Representation: Provides the Investor with the right to elect one or more members to the Company’s Board of Directors.

Tarter Krinsky & Drogin’s M&A team advises investors, entrepreneurs, and emerging companies in connection with their capital transactions. Please contact us if we can assist with your upcoming financing deal.