“The number one reason a start-up fails is that the founder gives up” Jason Calacanis, Angel
Some investors consider start-up companies as a hypothesis, and they try to figure out how the start-up company will grow quickly and be profitable, rather than discredit it. First, they reflect on the problem, and see through the solution, and can almost conclude why the experiment is going to be successful. Investors look at unfair advantages like the market, the product, etc. Therefore, founders should ensure that the problems are mandatory and frequent to attract early-stage funding.
During the early stages of a business venture, there can be difficulty on the part of both founders and investors in assigning a reliable and realistic value to the company. This is due to several factors, including the limited history and track record of the start-up as well as the unknown future of its business prospects and growth trajectory. This is where a Simple Agreement for Future Equity (“SAFE”) comes in, to postpone the valuation decision until a later time.
SAFE was originally introduced by YCombinator in late 2013. It was created to make easy the process of early investing in start-ups via seed financing. The SAFE was likewise presented when there was some measure of vulnerability around California law connected with lender registration and its possible application to convertible notes.
It is imperative that Start-ups challenged by the lack of funding consider SAFE. It is not a priced round. At the pre-seed, you may be presented with a Simple Agreement for Future Equity (SAFE). Do you know what a SAFE is or how it works, let us jump right into it:
WHAT IS A SAFE
A simple agreement for future equity (SAFE) is a financing agreement between a start-up and an investor that gives the investor the right to receive equity of the company conditioned on certain activating events, such as a future equity financing (known as a Next Equity Financing, typically led by an institutional venture capital (VC) fund. SAFEs have no maturity date until a conversion event occurs, and no accruing interest. SAFEs are simpler, less expensive, and less time-consuming to execute. Investors receive only a right to convert their SAFEs into equity at a lower price than the investors in the subsequent financing (based either on the discount or valuation cap in their SAFEs). The original SAFE was based on a pre-money valuation. In 2018, YCombinator amended its form of SAFE agreement to be based on a post-money valuation.
HOW DO SAFES WORK?
Start-ups need money, money to hire new staff, for marketing, but it is nearly impossible to attract new investors without discussing valuation and performance indicator data. While this may seem like trouble without a solution, the good news is that there is an investment instrument, known as a SAFE that solves it.
Example of How SAFE Agreements Work
Let us say you receive a $50,000 investment through a SAFE. Having in mind that assigning valuation to early-stage companies is very controversial, the start-up leverages on pre-money SAFE to find new investors to defer valuation to a future event. The investors are simply buying the right to equity in the future when the start-up has more traction and performance data that would allow an institutional investor to properly value the start-up. At this point, your $50,000 would convert into equity relative to the valuation of the priced round. Early investors ordinarily get an advantage for facing the risk of investing in new ventures, which includes discounts and valuation caps.
SIGNIFICANT TERMS IN A SAFE
SAFE agreements are powerful investing tools. However, there are important terms in the SAFE that you must understand. Four (4) terms are considered in this article, which include discounts, valuation caps, pre-money or post-money, and pro-rata rights.
SAFE agreements can include a discount. The discount is used if the SAFE investor money converts in future financing rounds and the valuation was at or below the valuation cap. For example, a 20% discount rate means an investor’s money would buy shares at $8m valuation if the priced round were $10m (20% discount). This means that the investor will be able to purchase shares at a discount on the future financing.
2. Valuation Cap
Valuation is like a tug of war, where the founders want the highest valuation, looking at the future expectation, and investors want the lowest valuation, they are more rooted in the present value. Investors are looking at valuation caps, this clause is another common term in SAFE agreements that investors can use to obtain a more favourable price per share in the future by setting a maximum convertible price.
A valuation cap is an upper limit obligation on the price at which a SAFE will convert to stock ownership in the future.
As an example, suppose a start-up is raising capital at a $10m valuation and the SAFE investor has a valuation cap of $5m. In that case, SAFE investors’ shares convert at the valuation cap ($5m) despite the start-up having just been valued at a $10m valuation. SAFE investors are typically happy if the valuation cap comes into play.
It is a substantial risk investing in start-ups, and this makes start-up founders to frequently offer valuation caps as incentives to bring in early investors. A valuation cap shields investors from unreasonably small equity conversion rates during subsequent price rounds. Most investors insist on a valuation cap, without one, their investment will be less if the company’s value starts to increase rapidly. Caps are not valuation, if the investor wants to term it as valuation, then the investors should be doing a priced round.
3. Pre-Money or Post-Money
Pre-money or post-money refers to valuation measurements that help investors and founders understand how much a company is worth. It’s one of the most essential terms in a SAFE agreement. Pre-money means the valuation is before new investor money. Post-money means the valuation including the capital raised in that round.
Assuming, before the raise, the company was valued at $5 million and got $2 million from the investor(s). The start-up at pre-money is valued at $5 million, so the post-money valuation is $ 5 million plus (+) the $2 million from the investor(s) is (=) $7 million.
4. Pro-Rata Rights
Pro-rata rights are rights contained in the Agreement that grants investors the option to add more funds to maintain ownership percentage rights following equity financing rounds. The investor will pay the new price versus the original price. These rights are the perfect way to keep powerful investors motivated to move forward with their investments over the long term.
There are various models of SAFEs, depending on the needs of the parties (Founder and Investor), lawyers can always tailor the SAFE to suit their needs. It is safe to say that SAFEs are very friendly for both founders and investors in raising early-stage funding. Wherefore, it is only wise to understand what it is that you are using, and to get quality advice while using it. As the examples in this article demonstrate, there are some intricacies to SAFEs that can be worked through, but usually require some foresight.
SAFEs have no maturity dates, and that places less pressure on the founders, which some of the time implies that the star beginning phases last longer than similar new companies supporting utilising obligations. If the new pursuit does not decisively work out, financial backers will lose their cash, with no monetary damage to the investor. This is a significant explanation while many founders like to offer SAFEs. Founders should take note of dilution, which is the outstanding shares plus (+) the reserved shares. However, pre-money SAFEs are quite tricky and more favourable for investors.
It is nearly impossible to attract funding as a Start-up from investors without discussing valuation and performance indicator data. While this may seem like trouble without a solution, the good news is that there is an investment instrument, known as a SAFE agreement that solves it. A SAFE is a Simple Agreement for Future Equity.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances. Our firm can be reached by email at email@example.com
Ayakpo Marlon is an Associate with Marcus-Okoko & Co., and he specializes in Business & Startup Advisory, Corporate Finance Law, and Regulatory Compliance.