[Editor’s Note] This is a guest post from Adam Sterling, Executive Director of the Berkeley Center for Law and Business, and a lecturer at VC Unlocked: Deal Camp at Berkeley. This post originally appeared on LinkedIn.

In 2014, 500 Startups, a global venture capital firm, took a little-known action that would help change the landscape of international venture finance. This action had nothing to do with investment dollars, new hires, or liquidation events. 500 Startups simply open-sourced their proprietary investment contract for early-stage investments, the KISS (“Keep It Simple Security”), to startups and investors around the world. In the next year, fellow venture capital giant Y Combinator followed suit and open-sourced their own proprietary investment contract, the SAFE (“Simple Agreement for Future Equity”).

KISSs, and SAFEs, and Notes, Oh My!

The public release of the KISS and SAFE, documents that do an admirable job of balancing the interests of investors and companies, has lowered the transaction costs of early-stage investments and helped unlock billions of dollars of global capital for new businesses.

Historically, startups raised their first round of outside capital through priced rounds, where a valuation for the company is negotiated, via the sale of preferred stock. This involved a relatively complex purchase agreement and a number of related agreements (and relatively substantial transaction costs). As the market for angel and seed investment grew, more and more of these early financing rounds were conducted through convertible notes — quasi-debt instruments that would allow the parties to avoid negotiating a valuation and instead simply wait to convert the notes at the subsequent priced round, usually at a discounted rate.

Today, the vast majority of early stage venture investments (e.g., angel, pre-seed, seed) are executed through one of three types of investment contracts/securities – the KISS, the SAFE, or a convertible note. The KISS and the SAFE, which are functionally close to being identical (although a comparison is provided below), are more or less truncated versions of the convertible note. Below is a brief summary of the key terms found in these early stage agreements and I’d encourage new investors and founders to spend some time exploring the KISS documents, SAFE documents, and another blog post I wrote about an obscure, but hugely impactful, issue surrounding convertible securities.

As I’ve said before, understanding the mechanics of venture finance is critical to success in the crowded venture space. To this end, I’d also encourage you to take a look at the popular UC Berkeley and 500 Startups 4-day executive education academy, VC Unlocked: Deal Camp (where I serve as an instructor and facilitator). In addition to helping to connect investors from around the world, Deal Camp takes a deep dive into convertible securities, valuations, negotiations, and much more.

Summary of Key Terms for Convertible Securities

Discount

This is one of the key financial terms of the convertible securities and represents the discount of the conversion price versus the price paid by new investors at the subsequent priced round. As an example, if a convertible security has a discount of 20%, and the startup subsequently does a priced round where it sells Series A stock at $1.00/share, the convertible security will convert at $0.80/share.

Valuation Cap

This is the other key financial term of the convertible security and represents a “ceiling” on the valuation, for the convertible investor, during the subsequent priced round. As an example, if a convertible instrument has a valuation cap of $5M, and the startup subsequently does a priced round where it sells Series A stock at a $10M valuation, the convertible security will convert to Series A stock at the $5M valuation (basically providing a 50% discount). Where a convertible instrument has both a discount and valuation cap, the investor will usually convert at whatever produces the lower conversion price.

Interest

Where a convertible security has an interest feature, that interest will generally accrue over the life of the security and be added to the principle when the security converts to preferred stock. Generally speaking, most convertible securities in Silicon Valley have very low interest rates (when they have them at all).

Acquisition Premium

While most early stage investors don’t expect their startup investments to be acquired before a subsequent priced round occurs, it does happen occasionally, especially in the case of an “acqui-hire” (where a larger company acquires a smaller business primarily for the purpose of acquiring its human talent). Some convertible securities will have a feature that provides the investor with either (a) their money back, (b) their money back times some multiple, or (c) an option to convert to common stock, in the case of an acquisition before conversion to preferred stock.

Amendment by Majority in Interest

Most convertible securities are sold in “rounds” or “tranches” – meaning a group of investors will each invest, around the same time, with the same terms, but each have their own investment contract. Furthermore, most convertible securities will have a term that allows amendments/modifications to be made with the approval of a majority in interest of investors in that round or tranche. As an example, if a startup does a seed round and issues $1M worth of convertible notes, investors accounting for $500,001 of that $1M would be needed to approve any amendments (and those amendments would apply globally to all investors in the round regardless of whether they approved the amendment).

Participation Rights

Often convertible securities will include a feature that allows the investor to invest additional funds during the subsequent priced round (but generally at the price paid by the new investors and not the discounted conversion price).

Representations and Warranties

Most convertible securities include a limited set of representations and warranties from both the company and investor. From the company side, these generally include warranties that the company is in good standing, duly authorized to agree to the investment, owns the necessary intellectual property to conduct its business, and is free from any litigation-related actions. From the investor side, these generally include warranties that the investor is authorized to agree to the investment and is an “accredited investor” (as defined by the Securities and Exchange Commission).

Most Favored Nation

Some convertible securities will include a term that provides that if the company issues convertible securities in the future, but prior to a conversion, with superior terms, than the investor may elect to exchange their convertible security to the one with the superior terms. As an example, if a startup issues a convertible note with a 20% discount and a year later issues one with a 30% discount, the investor with the 20% discount may be able to receive the 30% discount.

Comparing key terms of KISSs and SAFEs

NOTE: ADAM IS A GUEST POSTER AND ANY VIEWS OR OPINIONS REPRESENTED IN THE ABOVE POST ARE PERSONAL AND DO NOT REPRESENT THOSE OF 500 STARTUPS OR ANY OF ITS STAFF OR AFFILIATES UNLESS EXPLICITLY STATED. ALL CONTENT REPRESENTED ABOVE IS PROVIDED FOR INFORMATIONAL PURPOSES ONLY. 500 STARTUPS MAKES NO REPRESENTATIONS AS TO THE ACCURACY OR COMPLETENESS OF ANY INFORMATION CONTAINED IN THE BELOW POST AND HAS NOT TAKEN ANY STEPS TO INDEPENDENTLY VERIFY ANY INFORMATION HEREIN AND 500 STARTUPS ACCEPTS NO LIABILITY FOR ANY ERROR OR OMISSIONS APPEARING IN THIS POST. UNDER NO CIRCUMSTANCES SHOULD ANY OF THE ABOVE CONTENT BE CONSTRUED AS LEGAL, TAX OR INVESTMENT ADVICE FROM 500 STARTUPS OR ANY OF ITS AFFILIATES.

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