Texts with Founders: MFNs
Are they a lousy deal or free money?
Welcome to Texts with Founders — tested tactics for early-stage startups. This free newsletter is designed to give an inside look at how I work with other founders.
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Couple of updates before today’s post:
I’m hosting a happy hour for people exploring starting companies this Wenesday (8/30) in SF. Great guest list so far—engineering leaders from unicorns, sharp data and ML folks, and others with serious operations chops.
Congratulations to Adeel at MagicSchool (tools to fight teacher burnout) on surpassing 100k users and raising a $2.4M seed from some of the best edtech investors in the world—all within 3 months of launch.
Congrats to Nathan at Lex (the best word processor) for successfully spinning out the company from Every and raising $2.75M from True Ventures. I previously wrote about Lex in Startups make the future less scary.
MFNs — a lousy deal or free money?
A topic that's become increasingly more common in my texts with other founders is MFNs—specifically MFN SAFEs.
Something funny has happened with MFNs. When YC introduced their newest terms, which included an MFN SAFE, VCs protested, claiming they were not founder-friendly. Some of those VCs now market their own MFNs as "essentially free money."
So, are MFNs a lousy deal or free money? Neither is the correct answer. I'll explain why MFNs can be great for founders—but only when used thoughtfully.
First, two quick definitions:
SAFE = acronym for "Simple Agreement for Future Equity" — it's the most popular investment document for early-stage startups to take funding from angels and VCs
MFN = acronym for "Most-Favored Nation" — a clause that allows an investor to receive the same (or better) terms as any future investor.
When you have an MFN SAFE from an investor, you're combining…
The most commonly used investment document...
With a provision that enables the investor to have the best terms of any subsequent investor
Here's an example step-by-step scenario:
You raise $50k from me on an MFN SAFE
You raise $10k from a yolo angel on a $20M post SAFE
You raise $500k from a price-sensitive VC on a $10M post SAFE
You raise $500k from a fomo VC on a $25M post SAFE
In the above example my SAFE is now the lowest of the subsequent investment caps ($10M post).
MFNs are not a bad deal.
A particularly compelling element of MFNs is that they enable you to defer determining an immediate valuation for your company. This means you can spend the money invested via the MFN SAFE and do things that could increase the valuation assigned to it. Here's an example of how that might work:
I invest $50k on an MFN SAFE as your sole investor. You now have cash to spend to build your startup's value.
Perhaps you can use that cash I invested to get to $100k ARR.
Now you start talking to other angels, and the post-money valuation cap you take investments on is $12M post.
This now means my MFN investment is also $12M post. Had we decided on a cap valuation earlier (prior to you getting to $100k ARR), it would have likely been much lower ($4M vs. $12M, for example).
On the surface, MFNs seem like a good deal for founders and a bad one for investors. Generally, I think MFNs make little sense for investors unless some special circumstances are at play. Those could include but are not limited to the following:
The investor has ownership beyond the MFN (YC is the most well-known example of this with their 7% for $125k + $375k MFN)
The investor is pre-empting a round they believe will be ultra hot because they fear they might get cut out if they wait.
The investor is doing this to buy a seat at the table (similar to scout checks) so they can potentially lead a future round.
Is YC ripping off founders or pissing off investors by giving founders such a good deal?
I think of YC as a force for good in the world. Sometimes, a force for good can be corrupted, but I imagine YC believes their new deal is the best deal they've ever offered founders. By getting more money from YC, founders can make more business progress. That means they can potentially raise at commensurately higher valuations.
Much of the YC criticism from VCs tends to be centered around how the deal terms impact them more than how they help or hurt founders. We're again hearing some investors complaining about YC company valuations and how they feel that the MFN is primarily to blame. But the YC valuation complaints have existed long before the MFN was part of the terms—this is just the latest excuse some VCs use to be annoyed with YC.
MFNs are not "essentially free money."
Now that MFNs have become more mainstream, some investors are making it seem like their MFN investments are effectively charity work. Marketing MFN investments as "free money" is frankly bad marketing, and I hope investors stop doing it.
An MFN investment is like any other investment with a significant difference: you do not know what the future valuation will be. That means you are still determining what the dilution will be, too.
Be mindful of dilution.
The fact that the future dilution from the MFN investment is unknown becomes a bigger deal the larger the investment:
$50k investment at $5M or $10M post = between .5% and 1% dilution
$250k investment at $5M or $10M post = between 2.5 and 5% dilution
The more you raise on an MFN SAFE, the more you will likely focus on increasing the following SAFE valuations so that the MFN won't be too dilutive. One company I work with got a $250k MFN investment as their first check. This caused them to raise at $10M post because they wanted to avoid the MFN being assigned a lower valuation, leading to higher dilution.
MFNs are a valuable tool—when used correctly.
If an investor offers you an MFN, ask yourself why they're doing it. Is it because they want to pre-empt what they believe will be a hot round? Are they buying access to lead the next round? Something else? You will better understand an investor's behavior once you understand their incentives.
If the investors offering you an MFN are not using the standard YC version, run it by a lawyer to see if anything unusual is included.
Lastly, do some scenario planning around valuations following an MFN investment, so you know what dilution range you should expect.
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- Julian
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