Subscription Agreement

A Simple Agreement for Future Equity (SAFE) is a contract that says the investor gives the business money today and in the future when the business successfully completes a larger financing round, the investor will get shares at that time. The benefit? The investor gets their shares at a discount to the future funding round’s price per share. It’s a way of rewarding early investors for the risk they took on the business.

A SAFE is different from a Subscription Agreement since the investor gets their equity in the future rather than now.

An example of how a SAFE works

An investor invests $10,000 in your business and they get a SAFE, which says that if the business raises $1,000,000 in the future, the SAFE converts into equity and the investor gets shares in the company. The $1,000,000 funding round target amount is called a “qualified financing” or “qualified funding round”. The $10,000 investment converts into shares at a 20% discount from the share price reached in the future $1,000,000 round.

If the future qualified funding round raises $1,000,000 at $100 per share, the SAFE investor gets their shares for 20% off at just $80 per share. That means:

Other Investors: Without the discount, the other investors will only get 100 shares ($10,000 ÷ $100 = 100 shares).

SAFE Investor: With the discount, the SAFE investor’s $10,000 gets them 125 shares ($10,000 ÷ $80 = 125 shares). This larger number of shares allows the investor to keep a bigger equity position in the company or to sell their shares to other investors for the higher $100 price and pocket a 20% return on investment.

As a note, the qualified funding round amount ($1,000,000 in our example) is negotiated between the business and the investor.

A Convertible Note is a contract that says the investor gives the business money today and one of two things will happen (but only one or the other, not both).

1. Repayment. If the due date comes and goes, the business must repay the amount plus interest. This makes a Convertible Note a debt owed by the business to the investor.
2. Conversion to Equity. The second thing that could happen is that the Convertible Note converts into equity in the business.

So, a Convertible Note is different from a Subscription Agreement since the investor gets their equity in the future rather than now.

Let’s get into the second scenario from above in more detail since it’s what makes a Convertible Note unique.

The Convertible Note can be converted into equity in the future when the business successfully completes a larger funding round. The investor will get shares at that time based on the share price of the future round. The benefit? The investor gets their shares at a discount. It’s a way of rewarding early investors for the risk they took on the business.

An example of how a Convertible Note works

An investor invests $10,000 in your business and they get a Convertible Note, which says that if the business raises $1,000,000 in the future, the Convertible Note converts into equity and the investor gets shares in the company. The $1,000,000 funding round amount is called a “qualified funding round”. The $10,000 investment converts into shares at a 20% discount from the share price reached in the future $1,000,000 round.

If the larger future round raises $1,000,000 at $100 per share, the Convertible Note investor gets their shares for 20% off at just $80 per share. That means:

Other Investors: Without the discount, the other investors will only get 100 shares ($10,000 ÷ $100 = 100 shares).

Convertible Note Investor: With the discount, the Convertible Note investor’s $10,000 gets them 125 shares ($10,000 ÷ $80 = 125 shares). This larger number of shares allows the investor to keep a bigger equity position in the company or to sell their shares to other investors for the higher $100 price and pocket a 20% return on investment.

As a note, the qualified funding round amount ($1,000,000 in our example) is negotiated between the business and the investor.

Wait, isn’t this the same as a Simple Agreement for Future Equity (SAFE)? No, not exactly. 

You’ll notice this is all very similar to a Simple Agreement for Future Equity (SAFE). See the previous FAQ if you haven’t already. Although a SAFE is very similar to a Convertible Note, there are two key differences. The first is that a Convertible Note is a debt that must be repaid if it is not converted into equity, but a SAFE typically does not have to be repaid. Second, a Convertible Note charges interest and a SAFE is usually interest free.

Vesting means someone gets full ownership of their shares a piece at a time, usually over a few years.

For example, a 5 year equal vesting arrangement means the person gets 1/5th (20%) of the shares each year for 5 years so that at the end of the vesting period, they have all (100%) of their shares. Vesting can also be done through a “cliff”, which means all the shares vest after a period of time. For example a new employee may get shares in the company as an incentive to take a job and after 3 years of continuous employment, 100% of the shares vest. The 3 years is the “cliff” after which the vesting falls off.

A Subscription Agreement will include any vesting schedule you and the investor have agreed to.

No, a Subscription Agreement is not used to give someone stock options. For that, we use an Option Agreement and if the options are granted to employees, independent contractors, or consultants, we also usually also have a Stock Option Plan (sometimes called an Equity Incentive Plan).

Yes, the Subscription Agreement can be used for shares in a corporation.

Yes, the Subscription Agreement can be used for units in a partnership.

Equity means shares in a corporation or units in a partnership.

The basics

When someone invests in a corporation to become an owner of it, they get shares that represent their ownership in the business. Shares are a “share of” the ownership of a business. So if you’re the only owner of your business, you could have 100 shares or 100% of the ownership. If you have two owners, each could have 50 shares or 50% each of the business.

Some more details

Shares come in classes. There are two broad categories of shares: Common Shares and Preferred Shares. Common Shares are, well, the regular type (as the name suggests).

Preferred Shares are called “preferred” because they can have special rights attached to them. The primary benefit that makes these shares “preferred” is that they rank ahead of the Common Shares when the business is dissolved or winds down. That means that if the business is dissolved and there is enough money left after the company’s creditors (like banks and other lenders) are paid, the Preferred Shares get their investment back. Only after the Preferred Shares get their investment back will the Common Shares get anything that’s left over.

Shares can be voting or non-voting and you can also set them up in individual classes, like Class A Voting Common Shares and Class B Non-voting Common Shares.

Even more complexity, if you want it…

To add to the complexity, you can have sub-classes within shares called “Series”. For example, Class A Voting Common Shares, Series 1, or Preferred Shares, Series 1, Series 2, etc.

If you’re getting overwhelmed, don’t worry. You don’t need to get fancy with classes and series unless you have tax planning or professional investors involved. A typical share set up could look like this:

• Class A Voting Shares – used for founders and major investors
• Class B Voting Shares – used for minority investors that you want to have a say in some business decisions
• Class C Non-voting Shares – used for minority investors or people you pay with shares but should not be able to vote on business decisions
• Preferred Shares – if you’re a small business, you likely will only use Preferred Shares if your accountant suggests it as part of a tax planning strategy

There is a lot of flexibility when you structure a business. The important thing is to set up your shares in a way that works for you. If you’re in doubt, you can talk to a lawyer through the Made It Legal Marketplace to get some extra help.

Units in a partnership are very similar to shares. Units represent part ownership of the partnership. So if someone owns 50 units in the partnership out of a total of 100 units held by all the partners, that person owns 50% of the partnership.

Partnership units can be set up in different classes, much in the same way as shares. So, they can have different voting rights and other benefits.

A private placement is what we call a sale of shares (or units in a partnership) to a pre-selected set of investors rather than to the public through a stock exchange. So, it’s a private sale of an investment to a group of investors, usually friends and family, angel investors, or professional investors (venture capitalists, private equity firms, or “accredited investors”).

An Angel Investor is usually a wealthy individual that is a knowledgeable investor in your industry. They seek out attractive investment opportunities but usually don’t want to take too active of a role in the company.

There actually isn’t anything legally different about an Angel Investor compared to a Venture Capitalist, Private Equity Firm, or Accredited Investor. The difference usually comes down to motivation and how much oversight and involvement in the business the investors wants to have.

An Accredited Investor is an individual that meets certain knowledge and wealth requirements under investment laws. If the person is a professional investor with enough income and net worth, they are exempt from some of the more complicated investor disclosure rules that businesses must follow when taking investment money. So, it’s easier for a business to take the investment.

Private Equity Firms are much the same as an Accredited Investor, but are usually a group of Accredited Investors working together as a firm or an investment business.

A Venture Capitalist (also called a “VC”) is another word for a professional investor. They are usually Accredited Investors and their business is investing in private companies, often start-ups, and they usually have a plan to sell their investment in the future (called “exiting a position”). They often want a high degree of oversight in the business through regular reporting or being on the Board of Directors. Although there is a reputation out there about VCs being sharks, the right VC investors can be great partners in your business since they bring a lot of knowledge and connections with them along with the dollars they can put into your company.

Yes, friends and family can invest in your business. Actually, friends and family is a category of investor that is exempted from some complicated investor disclosure laws. So, getting investment from your close friends, business associates, and family can be a great way to boost your company with the dollars it needs to grow.

A Subscription Agreement is used with friends and family investors. We’ll make sure it’s set up for this type of investor.