Benefits And Risks For Startups


A Simple Agreement for Future Equity (SAFE) is a contractual agreement between a startup company and its investors. It exchanges the investor’s investment for the right to preferred shares in the startup company when the company raises a future round of funding. The SAFE sets out conditions and parameters for when and how the capital will convert into equity. Unlike a convertible note, a SAFE does not accrue interest or have a maturity date.

SAFE was introduced by Y Combinator (the world’s preeminent startup accelerator) in late 2013. It was designed for early-stage startups and seed stage investors to raise capital quickly and simply. Since then, almost all Y Combinator startups have used SAFE in early-stage fundraising. Outside of the Y Combinator community, the SAFE has become incredibly popular within the startup world due to its founder-friendly nature, simplicity and efficiency.

Y Combinator has drafted four versions of the SAFE. They are:

  1. SAFE: Valuation cap, no discount
  2. SAFE: Discount, no valuation cap
  3. SAFE: Valuation cap and discount
  4. SAFE: MFN, No valuation cap, no discount

Note that in the fall of 2021, Y Combinator removed number three, the SAFE: Valuation cap and discount from their website (without explanation). However, it remains a popular version of SAFE. The SAFEs are easy to use off the shelf with minimal amendment. However, investors and founders sometimes amend terms in SAFEs with the guidance of counsel to create their own variations.

High Resolution Fundraising: Benefits of SAFE Agreements for Startups

SAFE has been welcomed by the startup community for several reasons.

Fast and easy—SAFEs published on Y Combinator’s website are around six pages long. They are fairly simple and straightforward with fewer variables to understand and negotiate. This saves time in negotiation, which allows the transaction to move along in a faster and more efficient manner. It also saves associated costs in relation to the transaction.

No interest payment and maturity date—SAFEs remove features in convertible notes that give startup founders headaches, such as interest payments and maturity dates. Using SAFEs mean founders no longer have to worry about keeping track of interest or asking investors for extensions when maturity dates approach. This allows founders to better focus on growing the company.

No repayment of principal—SAFEs are founder-friendly and impose no obligation on the founders to repay the investment if the SAFE never converts into security. While this can be seen as a negative as the investors could be left with nothing, most professional seed stage investors understand the risks of investing in early-stage startups. However, SAFE is not suitable for investors who expect repayment of an investment should it fail.

High-resolution fundraising—A typical round of funding requires a lot of coordination to get investors aligned, signing documents and wiring money on a single close date. With the SAFE, startups can close with an investor as soon as both parties are ready to sign and the investor is ready to wire money. Y Combinator founder Paul Graham calls this high-resolution fundraising.

Risks of SAFE

Despite all the convenience discussed above, SAFE is sometimes not so simple or safe.

No equity stakes—Being a SAFE investor does not entitle one to the rights of a stockholder. SAFEs are not equity stakes in the company, so SAFE investors are not protected under state corporate law or federal securities law. Instead, SAFE investors are entitled to a future equity stage only if certain triggering events occur. If the triggering event never occurs, a SAFE investor can be left with nothing.

Too easy—Ironically, the main feature of the SAFE—its simplicity—is also a bug. Because it’s become so easy for founders to raise money on SAFEs, many founders raise a bunch of money without understanding the impact on the cap table. Then they have a rude awakening when the SAFEs convert, and they realize how much of their company they’ve given away and how much it has diluted them.

SAFEs Convert Into Preferred Stock in Equity Financing

The SAFE converts into equity at the next round of funding where the company sells preferred stock at a fixed valuation. Unlike qualified financing in the convertible note, there is no minimum size of the round.

Upon an equity financing, the capital that the SAFE investor invested converts into shares of preferred stock in the company. The shares will have the exact same preferences, rights and restrictions as the preferred shares of the new investors in the equity financing (new investors). Founders should remember that when they are negotiating the terms with the investors in an equity financing, they are negotiating for the shares of the new investors as well as the SAFE investors. The number of preferred shares that the SAFE will convert into depends on whether there is a discount and/or a cap.

SAFE Discount

The discount in a SAFE is used as a mechanism to address the higher risk of investment that SAFE investors take when investing in an early-stage startup. It is a discount off the price per share paid by new investors in the equity financing. The discount may range anywhere between 5% to 30%, with 20% being the norm.

For example, if the SAFE investors enjoy a 20% discount and the investors in the subsequent round of financing (new investors) purchase preferred shares at $1 per share, the SAFE investors would only pay $0.80 per share. The higher the discount rate, the more equity SAFE investors would receive for their investment.

The discount rate is clearly stated in bold at the top of the agreement. It is written as 100% less than the discount rate; for example, a 20% discount is written as 80%, and a 10% discount is written as 90%.

Sometimes the discount alone may not be sufficient in protecting an early investor’s interest. Thus, some investors will use a valuation cap in SAFE to protect their interests in circumstances where the company is growing a lot more rapidly than expected.

Valuation Cap

If the SAFE has a valuation cap, it’s typically the most heavily negotiated term. What is a valuation cap, and why does it receive so much attention? A valuation cap is the highest valuation at which the amount invested in the SAFE would be converted into shares. It is the maximum valuation that the SAFE investor will pay, regardless of the actual valuation of the equity financing.

For example, if the SAFE valuation cap is $10 million and the new investors are investing in the company at a $20 million valuation, then SAFE investors will be paying half price for their shares relative to the new investors. (They can buy twice as many shares for their money as the new investors.)

Founders should always keep future rounds in mind when they set a cap on their SAFE. The SAFE investors are taking a risk because they are investing earlier in the startup when there is increased uncertainty, so they should be rewarded for that early investment. But you probably don’t want them to be buying at half price of the new investors. If the cap is too low, founders risk giving up too much equity to the SAFE investors and diluting themself in the process.

What’s Better for Founders: Discount or Cap?

Generally, the ideal situation for founders is for the SAFE to be uncapped and discounted. This rewards the convertible note investor for taking on early risk. It also avoids the challenge of assigning an arbitrary value to the company, which could be too high or too low.

Some investors insist they will “never” invest in a SAFE without a valuation cap. However, the outcome depends on the bargaining power of the parties involved. At the pre-seed stage, an uncapped SAFE could suggest the company is attractive and has some leverage in negotiations, which could help draw in better investors for later rounds of equity financing.

However, not all early-stage startups have investors eagerly waiting to invest. When negotiating a valuation cap, founders should ensure that it is set at a reasonable level—ideally higher than what the company could achieve if it were to do a priced equity round of financing.

Conclusion

A solid understanding of these terms will help founders collaborate with their legal advisors to secure an advantageous deal for themselves and their team. Check out this video to learn more. For a deeper dive, read this guide.



Source link: https://www.forbes.com/sites/kylewestaway/2023/01/06/understanding-safe-agreements-benefits-and-risks-for-startups/

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