Most Favored Nation (MFN) Clause

If you’ve ever bought something before, only to see it go on sale a few days later — you know how frustrating it can be.

Now imagine you’re a VC, deploying billions into early-stage companies. You might be writing checks for tens or hundreds of millions of dollars and the slightest changes in terms can have a drastic impact on your return. You’re always looking for ways to protect your investments and one of the most straightforward ways is through the Most-Favored Nation (MFN) clause. 

The idea is simple: if a future investor negotiates better terms, you get them too.

As a startup founder, it might seem intuitive to agree to the most favored nation clause, especially if it's a stipulation of the deal—but there are some things you should know. This article provides an overview of MFN clauses in the world of venture capital— the what, why, and how, and the aspects you should consider before agreeing to this clause.

What is the most favored nation clause in venture capital?

The most-favored-nation clause — also referred to as the MFN clause — enables early investors to receive the same terms as later investors, if the later investor received “better” terms than the earlier investor did.

MFN clauses are most common in venture capital, particularly in early-stage investments, where a Simple Agreement for Future Equity (SAFE) or Convertible Note is used. This is because a SAFE is typically the first round of institutional capital a startup raises, so the investors may receive less favorable terms — a higher valuation cap, lower liquidation preference, and the absence of anti-dilution protection.

What is the most favored nation clause in international trade?

Similarly to the effect of the most favored nation clause in venture capital, in international trade, MFNs protect the rights of all the involved parties in a trade negotiation. It prevents the unfair practice of favoring one trade partner over another. Members of the World Trade Organization (WTO) must extend special rights, trade privileges, or concessions given to one country, to all the other countries.

When fundraising, where is the most favored nation clauses typically seen? 

If you’re raising capital as a startup, there are two places you’ll commonly see the most favored—Simple Agreements for Future Equity (SAFE) and Convertible Notes, here’s how the MFN applies to each.

Simple Agreement for Future Equity (SAFE)
If you’re early in your journey, one of the most common forms of financing you’ll come across is a SAFE. SAFEs enable pre-seed startups to raise capital from investors. They are fairly straightforward agreements with standard language and non-negotiable terms.

Like warrants in venture debt, SAFEs allow investors to buy shares in future priced rounds at a discount once certain milestones are met, however, unlike convertible notes, they are not debt and do not accrue interest.

Convertible Note
Convertible notes are a form of debt financing used by startups that don’t have a valuation. The note starts as debt and converts into equity upon certain milestones being achieved. Convertible notes can be used in conjunction with SAFEs, although they typically come after the SAFE agreement has been executed.

What’s the difference between SAFEs and Convertible Notes?

SAFEs are a convertible form of equity used by accelerators, early-stage investors, angels, and venture capitalists to invest in early-stage startups. Whereas convertible notes are a form of convertible debt, that accrues interest and has a set maturity date. Convertible notes are more indirect than their SAFE counterpart and are structured to help early-stage businesses scale without encumbering them with a valuation.

How does the most favored nation clause work? 

The idea of the Most-Favored Nation clause is that all early investors are eligible to receive the same terms as later investors if the terms of the later investors are better than the ones they have.

Imagine startup X is raising capital via a SAFE. They raise $100,000 from investor A via a SAFE with no discount rate at a valuation cap of $1,000,000. In exchange for investing the $100,000, the venture capitalist receives a 10% ownership stake in the company. As a stipulation of the deal, the investor receives the most favored nation clause.

Three months pass and Startup X decides to raise another $100,000 from new investors via a SAFE. But this time, there is a discount rate of 5% and a valuation cap of $900,000. Investor A invokes their right of the most favored nation clause and seeks to receive the same terms as the new investors.

A few more months pass, and now the startup is raising a seed round of $300,000 at a post-money valuation of $900k and a strike price of $3. Both groups of investors convert their SAFEs into equity and purchase 10% of the company at a strike price of $2.85 per share. If investor A did not have the MFN clause, he wouldn’t have been able to exercise his SAFE.

Generally speaking, these are the factors that the MFN clause applies to related to SAFEs.

• Valuation Cap: This is the dollar amount that the SAFE agreement is satisfied and the investor can convert into equity in the company.
• Discount Rate: This is the discount on the current strike price that the investors receive for converting the SAFE into equity.
   

Generally speaking, these are the factors that the MFN clause applies to for convertible notes.

• Interest Rate: This is the rate that an investor earns while the note is active, it typically ranges from 2-8%. Unlike traditional loans, interest on convertible notes is paid through additional shares.
• Maturity Date: This is the date that the note converts into equity in the company.
• Valuation Cap: This is the dollar amount that the note is converted into equity at.
• Discount Rate:  This is the discount on the strike price that the investors receive for converting the note into equity.

Why do investors & startups agree to MFN clauses?

Early investors often request the most favored nation clause because they don’t want to receive worse terms than later investors who arguably take on less risk. It helps ensure that they receive the best deal, even if they decide not to participate in future rounds. It also aligns the interests of the investor and the startup, because the founder has to be more capital efficient and think twice before offering a ‘deal’ to later investors.

Early-stage startups often agree to MFN clauses because they don’t have a choice—these clauses are often necessary to secure the capital they need to hire engineers, build products and go to market. They also agree to MFN clauses because they can make an investment in their company more attractive to venture capitalists.

Pros of agreeing to the most favored nation clause?

• It makes an investment in your company more attractive to investors and can be leveraged to secure better terms out of the gate
• It aligns your interests with the interests of your investors and protects the interests of small, medium, and large investors alike

Cons of agreeing to the most favored nation clause?

• MFN clauses are highly partial toward the investors and offer minimal benefits to the startup. 
• It reduces the financing flexibility you have down the road. E.g. should you want to bring on a strategic investor and incentivize them with better terms, you’d be forced to give those same terms to other investors with the MFN clause
• It can drive a wedge between your early investors if some of them have the MFN clause and others do not, leading to headaches later on
• MFN clauses never go away

Common pitfalls to avoid when agreeing to the MFN clause?

If you’re in the process of negotiating term sheets with investors and come across the most favored nations clause, there are some common pitfalls you should avoid. These include: 

• Not seeking counsel: Before you agree to any terms, stipulations, or contractual provisions, seek legal counsel. 
• Giving MFN clauses to everyone: It can be tempting to give MFN clauses to all of your early investors—don’t do it. The challenge comes later on, when you want to bring on a strategic investor, but can’t because it would trigger all of the MFN clauses and cost significantly more than you expected.
• Agreeing to MFN clauses late in your lifecycle: MFN clauses are most prevalent in early-stage rounds, but they occasionally come up in late-stage rounds. If you’re past your Series A, consider avoiding it.

Final thoughts on the most favored nations clause?

In general, you shouldn’t think of the most favored nation clause as being a “bad” provision, because it’s not. It’s something that investors require if you’re an early-stage company that’s raising funding, and it is okay. Rather than giving out MFNs to everyone who asks, think of them as a tool in your metaphoric fundraising tool belt—use it when you need it, sparingly.