Agreement for Future Equity (AFE): A Comprehensive Guide
If you are an entrepreneur looking to raise capital for your startup, you may have come across the term Agreement for Future Equity or AFE. An AFE is a legal agreement between a company and an investor that outlines the terms and conditions for the investor to acquire equity in the company at a future date, usually upon a specific event like a round of funding or an exit.
An AFE is often used when a startup is in its early stages and doesn`t have a clear valuation or when the company is not ready to issue equity at the current time. It allows founders to secure commitments from investors without having to give up equity immediately. Instead, both parties agree to a future valuation, and the investor is granted the right to purchase a percentage of the company`s equity at that future valuation.
How does an AFE work?
An AFE typically has four main components:
1. Valuation: The agreed-upon valuation of the company at a future date, usually upon a specific event like a round of funding or an exit.
2. Percentage: The percentage of the company`s equity that the investor is entitled to purchase at the pre-agreed valuation.
3. Trigger event: The event that triggers the conversion of the AFE into equity. This could be a round of funding or an exit.
4. Terms: The terms and conditions of the agreement, including any restrictions on the sale of the equity.
When the trigger event occurs, the AFE converts into equity at the pre-agreed valuation, and the investor is entitled to purchase the agreed-upon percentage of the company`s equity. For example, if the agreed-upon valuation is $10 million and the investor has the right to purchase 10% of the company`s equity, they would have the option to purchase equity worth $1 million.
Advantages of an AFE
1. It allows founders to secure commitments from investors without having to give up equity immediately.
2. Investors are incentivized to support the company`s growth, as their returns are tied to the company`s future success.
3. An AFE can be used to attract investors who are hesitant to invest in a company without a clear valuation.
Disadvantages of an AFE
1. An AFE can be complex and expensive to draft, negotiate, and execute.
2. There is a risk that the company`s valuation at the trigger event may be lower than the pre-agreed valuation, resulting in the investor not seeing a return on their investment.
3. An AFE can create additional administrative and legal burdens for the company and its founders.
Conclusion
An Agreement for Future Equity is a relatively new and innovative way for startups to raise capital without giving up equity immediately. It provides founders with a flexible and attractive option to secure commitments from investors while retaining more control over the company`s equity. However, an AFE can create additional legal and administrative burdens for the company and its founders, and there is always a risk that the trigger event may not result in the desired valuation. Overall, an AFE can be a useful tool for startups, but careful consideration should be given before deciding whether to pursue this option.
