Within the startup and investor landscape, SAFEs and convertible notes are quickly becoming the commonplace type of investment document for early-stage companies. This may be because it only requires the company and investor to negotiate and sign a single document. Indeed, there is no requirement to agree on a valuation. A SAFE is also an attractive way to provide funding to a startup between major equity investments because of its speed and simplicity. This article will unpack SAFEs as a way to raise capital for your startup.
What Is a SAFE?
SAFE stands for a Simple Agreement for Future Equity. It is a document that allows an investor to give money to a company on the basis that it will convert to equity upon specific events occurring. These trigger events typically include:
- the sale of a majority of the shares in the company ( share sale);
- the sale of all of the assets used by the company ( business sale); or
- investment in exchange for shares in the company (equity financing).
In considering the investment options available to you, you can discuss SAFEs alongside convertible notes. Importantly, you should understand their differences and which type of investment is best suited for your startup.
The main difference is that convertible notes have a maturity date whereby you will need to repay the investment amount on the agreed date, unless a trigger event occurs first. As a result, convertible notes sit on the company books as a loan, whereas SAFEs do not. SAFEs can provide more comfort to companies because they do not have to pay back the investment amount if the trigger events do not occur.
Investors in New Zealand may still have some hesitancy to invest via SAFEs as they are a fairly novel type of investment document. SAFEs have come out of the US and gained their popularity from the accelerator Y Combinator. Investors may also determine that SAFEs lack certainty as their investment amount will never be repaid or convert to equity if one of the trigger events does not occur. With that said, there can be protections added to the document to make it more friendly to investors.
When investors invest in a company via a traditional equity financing round (cash in exchange for shares), they will pay the agreed market value for the shares that they receive. This involves the investor and company agreeing to the company's valuation. Note that this is often the most difficult point to agree on, especially for early-stage startups. This is because valuing your company can be time-consuming and differing views can cause relationship breakdowns between the parties. A SAFE provides a simple answer to this issue as you do not need to agree to a valuation of the company. Accordingly, the SAFE converts based on the price set at the next equity financing round. However, you can add some terms to protect and incentivise the investor. These include:
|Valuation cap||The top end of the company's valuation. The valuation cap protects the investor where they have invested early via a SAFE, and the company's value increases astronomically in the next equity financing (trigger event). Without this protection, the investor's investment amount would result in a decreased number of shares.|
This is the percentage decrease in the company valuation to calculate the number of shares that the investor will receive based on their investment amount. As discussed, this is determined by the next equity financing round. The discount is typically around 80%, meaning that if the equity financing investor was paying $1.00 per share, the SAFE investor would pay $0.80.
Note, it is not common for investors to receive both the benefit of a valuation cap and a discount. The reason is that they protect the investor from the same thing – the company vastly increasing in value from the time the SAFE is entered until the trigger event and conversion.
Typically as part of an equity investment, the company would provide the investor with a copy of its shareholders agreement. Next, the investor would review this document as they need to sign it if the negotiations are successful. Often there is a large amount of time spent negotiating changes to the company's shareholders agreement. This can add time to the investment timeframe, which is a key benefit of a SAFE. However, at a certain point, the investor will need to sign the company's shareholders agreement.
If parties do not contemplate this during the SAFE negotiation, it can cause tension between the investor and company once the trigger event occurs and the investor receives shares. Therefore, the SAFE should state that the investor must sign the company's shareholders agreement. Also, negotiation of this document should be agreed upon when the investor is entering the SAFE. In turn, this can detract from the key benefit of a SAFE, being its speed and simplicity.
A SAFE can be a quick and straightforward way for a company to secure capital from an investor. In this investment, an investor and company do not need to agree to a company valuation. This is a challenging task for an early-stage company, especially when generating revenue. However, because the number of shares that the investor will receive depends on the company's future valuation upon a trigger event, you and your investor can add certain protections. These include a valuation cap or a discount but rarely both. While this investment is fairly simple, some complexities should be considered, like changes to the company's shareholders agreement.