This research paper was originally authored by Abdulrahman Sami Al-Jandal, It was written on February 6, 2024, with the intention of enriching the legal and business literature relating to startup financing instruments.
Introduction
In recent years, the region has witnessed remarkable growth in entrepreneurship and the emergence of technology-driven startups. Government programs, accelerators, and investors have increasingly supported innovation-led economic development, creating a rising demand for robust legal frameworks governing investment and future equity financing.
Despite this momentum, there remains a noticeable shortage of Arabic-language legal analysis addressing future ownership investment contracts—one of the core tools enabling early-stage startup growth. Through working on multiple venture investment agreements, it became evident that founders and investors alike need clearer guidance on how these instruments work, how they differ, and how risks should be managed.
This article aims to fill that gap by outlining:
- Why startups rely on future equity financing mechanisms
- The key types of instruments used (SAFE, Convertible Notes, KISS, OQAL)
- The critical clauses that must be negotiated
- Legal precautions essential for both founders and investors
It also serves as an introduction to a broader series of detailed legal reviews that will follow.
1. Why Startups Need Future Equity Financing Agreements
Startups typically move through four commonly recognized stages before reaching financial stability:
1. Pre-Seed Stage
The idea exists but has not yet been executed.
2. Seed Stage
The concept is transformed into an early version of the product or service.
3. Pre-Series A Stage
The company begins expanding operations, acquiring customers, and generating revenue from its core activity.
During these early stages, founders rely heavily on external funding to build products, hire employees, and establish a market presence. As a result:
- Financial statements often show significant losses, sometimes exceeding half of the startup’s paid capital.
- Investments appear as current liabilities, creating the impression of debt—often misunderstood by inexperienced investors.
- The company typically generates no profit for an extended period.
To finance growth without committing to immediate share issuance, founders often accept investment via future equity agreements. These allow angel investors to inject capital now, with conversion into shares postponed until a later valuation event or a priced investment round.
4. Priced Round (Series A and Beyond)
At this stage, the company becomes mature enough to establish a fixed share price, enabling investors to enter directly without the need for conversion instruments.
Not all startups follow this sequence rigidly—some leap directly to profitability or early priced rounds—but the framework explains why future equity contracts exist.
2. Types of Future Equity Financing Agreements
Any agreement containing binding obligations is, by definition, a contract—regardless of its title. The four most common instruments used in early-stage startup financing are:
1. SAFE Note (Simple Agreement for Future Equity)
A high-risk instrument favoring the founder, where:
- No maturity date is required
- No interest applies
- Conversion occurs upon a qualifying event
- It is not classified as debt, despite sometimes appearing under liabilities
SAFE notes are simple, founder-friendly, and reduce obligations in case of startup failure, but expose investors to substantial risk.
2. Convertible Note
A traditional debt instrument, featuring:
- A specific maturity date
- Interest (including prohibitive interest under Islamic finance)
- Automatic conversion into equity or repayment
This structure protects investors by giving them creditor status during liquidation and ensuring repayment or conversion at maturity.
3. KISS Note (Keep It Simple Security)
A balanced hybrid between SAFE and Convertible Notes, offering:
- No interest
- A clear maturity date
- Enforceable legal protections
- Automatic adjustments for recapitalization or stock splits
- Classification closer to equity than debt
KISS notes distribute risk more evenly and are often considered more equitable for both parties.
4. OQAL Note
A two-part instrument designed to align with Islamic principles:
- An interest-free loan (Qard Hasan)
- A promise to transfer ownership in the future
However, it presents challenges:
- Splitting the agreement into different documents increases complexity
- It assumes the underlying structure is a loan, which is inaccurate for SAFE or KISS
- Investor protection is weak, particularly if the ownership promise is not fulfilled
Thus, while offering a partial solution to the issues in Convertible Notes, OQAL notes introduce structural complications.
3. Key Clauses in Future Equity Financing Agreements
Regardless of structure, all future equity contracts rely on several core clauses:
1. Valuation Cap
The maximum valuation at which investment converts into equity.
It directly determines the investor’s future ownership percentage.
2. Discount Rate
Applied in post-money rounds to reward early investors if valuations fall or stagnate.
3. Conversion Timeline / Maturity Date
Commonly 18–24 months.
- Shorter periods favor investors
- Longer periods favor startups
4. Governing Law & Arbitration Clause
Must specify:
- Jurisdiction
- Arbitration rules
- Notice procedures
Ambiguous clauses can render rights unenforceable.
5. Voting Rights
Critical for substantial investors, though often omitted in early-stage notes.
6. Exit Rights & Share Issuance Protections
Including:
- Right of first refusal
- Pre-emption rights
- Tag-along and drag-along protections
These ensure equitable exit opportunities.
4. Essential Legal Precautions for Founders and Investors
A. SAFE Note Precautions (Investor Risk)
Investors should:
- Add liquidation preference rights
- Define a mandatory conversion deadline
B. Convertible Note Precautions (Founder Risk)
Founders should:
- Limit investor entitlement to conversion only, not repayment
- Negotiate favorable maturity terms
C. KISS Note Precautions (Balanced Risk)
Investors should secure:
- Preferred shares upon conversion
- Rights to adjust terms in future rounds
- Pre-emption, refusal, and tag-along protections
D. OQAL Note Precautions
Both parties must evaluate:
- The binding nature of the Qard Hasan loan
- The enforceability of the ownership promise
- The “commercial event” clause, which is a frequent source of dispute
Conclusion
The startup ecosystem continues to evolve rapidly, bringing new financial models, investment tools, and legal challenges. Founders and investors must understand the implications of each financing instrument—SAFE, Convertible, KISS, and OQAL—to ensure fair, transparent, and enforceable agreements.
If you are raising capital, negotiating with investors, or evaluating the right financing instrument for your startup, our expert consultants can help you:
- Structure agreements that protect your rights
- Evaluate risks and align terms with your goals
- Ensure legal compliance and enforceability
- Navigate negotiations with confidence
Contact our consulting team today for tailored advisory support and professional guidance at every stage of your funding journey. Contact Our Experts