Understanding Most Favored Nation Clauses in Startup Deals

Key Takeaways

• A most favored nation clause (MFN) ensures early investors receive the same favorable terms as later investors.
• MFN clauses are common in convertible notes and SAFEs in startup financing.
• MFNs promote fairness but may limit startup flexibility and complicate future fundraising.
• Different types of MFN clauses exist, such as "narrow" and "broad" MFNs, and each has strategic impacts.
• Antitrust laws may scrutinize MFN clauses in certain industries.
• It's crucial to work with an experienced attorney to draft and manage MFNs effectively.

What is a Most Favored Nation Clause?

Most favored nation startups are new companies that have a most favored nation or MFN clause in agreements with investors. This clause keeps later investors from getting better terms than the first investors, and it's completely different from the clause that involves countries. Most favored nation clauses are terms in many convertible notes. Some clauses make sure all parties in a contract get equal terms. MFNs usually last until the next round of financing, also called an equity round, starts.

Types of Most Favored Nation Clauses

Most favored nation clauses can vary widely depending on the agreement's scope:

• Narrow MFN: Guarantees the same terms only if another investor is offered a lower price or better terms within a limited context.
• Broad MFN: Ensures the first investor gets the benefit of any better terms offered to future investors across multiple aspects of the deal, such as price, discounts, caps, or governance rights.
• Standstill MFN: Common in mergers and acquisitions, this type restricts a company from offering better terms to others for a set period.

Choosing the right MFN structure helps balance fairness to early investors and flexibility for future fundraising.

Convertible Notes: What Are They?

Convertible notes are loans from investors that convert into equity or stocks when the company reaches prenegotiated milestones. An MFN clause in a convertible note keeps another investor from getting more equity for a similar loan when the company is more successful.

Why is a Most Favored Nation Clause Important?

MFNs let smaller first investors get the same favorable terms as larger companies that take part in the next round of investment. Many businesses rely on friends and family for the first investment. MFNs encourage good relations between founders and investors. Some MFN notes even include a lower valuation cap than the first angel notes. That way, the lack of a cap can't give later investors a better deal. MFNs are a great way to attract and reward your first investors, including friends and family. They let startups show early successes to venture capital firms, angel investors, and others instead of relying on the potential of a great idea to get investments.

Potential Legal and Antitrust Issues

While MFNs can protect investors, they sometimes attract regulatory scrutiny, especially in industries like healthcare, technology, and e-commerce​. Government agencies such as the Federal Trade Commission (FTC) and Department of Justice (DOJ) have challenged MFNs that may lead to anticompetitive behavior, like discouraging lower pricing to new entrants. Startups should be cautious when drafting MFNs that could be interpreted as limiting competition, especially in highly regulated sectors.

Reasons to Consider Using a Most Favored Nation Clause

• A most favored nation clause makes startups more appealing to investors and reduces costs. Even angel investors often require hundreds of thousands of dollars in capital without an MFN.
• An MFN clause on an uncapped convertible note balances a company's desire for no valuation cap with an investor's worry that one could be issued to another investor later.
• It also reduces losses for investors.

Reasons to Consider Not Using a Most Favored Nation Clause

• Mistakes are easy without experience, so friends and family should be accredited investors. They can also hire a lawyer experienced with startups.
• Some most favored nation clauses keep businesses from ever getting a better deal than the first investment with anyone.
• A most favored nation clause reduces flexibility for startups. It forces businesses to miss out on money from investors or trigger the clause and change the investment terms.
• Since they can't grow as fast, companies with MFN agreements are less appealing to new investors. They also can't offer better terms than the investors during the first round of financing received.
• Disagreements between founders and investors over most favored nation clauses often lead to lawsuits.

Alternative Structures to MFN Clauses

If flexibility is a priority, startups might consider alternatives to traditional MFN clauses:

• Discount-Only Provisions: Offer early investors a guaranteed discount rather than full parity on all terms.
• Valuation Cap Adjustments: Instead of an MFN, provide a valuation cap that favors early investors but doesn’t tie future negotiations.
• Side Letters: Customize agreements with specific investors without universally applying changes to all past investors.

These approaches offer early investors some protections without fully locking in future fundraising terms.

Terms You Should Know

• A friends and family round is a financing round for only friends and family. They often have friends and family clauses that include MFN agreements.
• A valuation cap converts an investor's loan into shares when the share price reaches a maximum value.
• A valuation discount gives the first investor a discount on the share price decided in the IPO.
• SAFE, the Simple Agreement for Future Equity, is a seed-stage financing tool that provides a faster, less expensive alternative to convertible debt financing. Y-Combinator partner and attorney Carolynn Levy made it short and standardized. Since investors only buy the right to get preferred stock during a financing round, there's no interest rate. If there's an acquisition or IPO, the SAFE holder can get his or her money back or convert the SAFE to common stock.

How Favored Nation Clauses Work

In a typical scenario, an investor contributes $10,000 to a company and both parties agree to include an MFN in the convertible note. Then, a new investor offers $250,000 as long as their convertible note comes with a valuation cap or discount. The company must tell the first investor about the new investment and the new terms. If they like the terms, the investor can ask to have the terms of their convertible note changed. If the convertible note reaches its maturity date and there's no other financing round scheduled, the startup should negotiate with the investor to extend the terms.

Often, the first investor is a family member or friend who invests money to help companies develop their products and get more funding. These convertible notes are called F&F notes, and they ensure that, at best, friends and family will get the same terms as your first angel investors. Since friends and family take more risks, you can include language in your F&F MFN that gives them a lower valuation cap than your fist angel notes. This means more dilution, but it's a great way to thank your very first investors.

Many startups also choose SAFE MFNs with no valuation cap for the first investors, and then later issue a SAFE with better terms to the later investors. The changes are called an MFN Amendment Provision. Most MFNs have a countdown date or deadline to protect the startup, whether they use a convertible note or a SAFE.

Steps to File

1. Speak to an experienced attorney.

   Service providers, vendors, business partners, and investors often ask for special terms, exclusivity deals, or most favored nation clauses. A lawyer can tell you whether you need an arbitration clause, a limitation of liability, non-disclosure agreements, or other measures.

2. Learn about intellectual property laws and compliance regulations for your industry. 

   An attorney can help you file a patent if needed before you start selling your product and talking to investors.

3. Get initial funding.
4. Sell, merge with another company, or hold an initial public offering or IPO.

All these processes affect your agreement differently depending on the provisions in your MFN clause.

Best Practices When Using a Most Favored Nation Clause

• Draft Clearly: Specify whether the MFN applies to all terms or only specific ones (e.g., valuation cap or discount rate).
• Set Expiration Triggers: Limit the MFN clause's applicability until a specific future event, like the next priced equity round, to avoid indefinite obligations.
• Disclose MFNs Transparently: Inform all new investors if MFNs apply to avoid disputes.
• Consult an Attorney: Legal review ensures that MFNs align with your fundraising strategy and don't trigger antitrust concerns​.

Working with experienced legal counsel is critical to balance investor incentives with your company’s long-term growth.

Frequently Asked Questions

1. What does a most favored nation clause do?

   A most favored nation clause ensures that early investors or partners are entitled to the same favorable terms as later investors if better terms are offered later.

2. How long does a most favored nation clause last?

   Typically, an MFN clause lasts until the next priced equity financing round, but it can vary depending on how the agreement is drafted.

3. Can a most favored nation clause hurt a startup?

   Yes, MFNs can restrict a startup’s flexibility in negotiating with future investors, potentially slowing fundraising and growth.

4. Are most favored nation clauses legal?

   Yes, but in some industries and circumstances, MFN clauses may attract antitrust scrutiny if they have anticompetitive effects.

5. Should I use an MFN clause in my SAFE agreement?

   It depends on your fundraising strategy. MFNs can help attract early investors but may complicate future rounds if not carefully structured.

If you need help with your most favored nation clause or other parts of your startup agreement, you can post your question or concern on UpCounsel's marketplace. UpCounsel only accepts the top 5 percent of lawyers to its website. The site has a diverse choice of the nation's best startup attorneys. You can easily find a lawyer to help you negotiate or tell you about other aspects of your business. Lawyers on UpCounsel come from law schools like Harvard Law and Yale Law. They have an average of 14 years of legal experience, and many work with or for companies like Google, Menlo Ventures, and Airbnb.