Is a SAFE Capital Option…Safe?
SAFEs have emerged a significant vehicle for new enterprises to raise capital, but it is not an investment vehicle free from risk.
In our last article, Raising Money for Startup Enterprises. Enter the SAFE we left Pedro pondering whether to use Simple Agreements for Future Equity (or “SAFE”) to help raise capital for his company, Gamer Alert. In that article, we discussed the Valuation Cap and the Discount Rate, which are two important terms of many SAFEs. In this article, we will discuss briefly other features of SAFEs.
The Valuation Cap Revisited
To recap the CAP, let us say a SAFE investor has agreed to invest $500,000 in a start-up business, with a Valuation Cap of $10 million. What this means is that if there is a triggering event, such as a capital raise or a business purchase, which yields a company valuation that exceeds the Valuation Cap, the investor would be entitled to receive shares at more favorable pricing based on the lower Valuation CAP to which the parties agreed in the SAFE.
On the other hand, if the SAFE includes a discounted rate, like 20%, and if there is a triggering event yielding a valuation less than the Valuation Cap, the investor could still receive shares at a discount. Obviously, without the company’s undergoing a formal valuation, the Valuation Cap can involve some guess work on the part of both the company and the investor. CAPS that are too low could end up seriously diluting the equity held by a founder. If CAPS are too high, it may discourage SAFE investors from undertaking an investment.
What founders should be conscious about is that SAFEs implicitly promise to convey investors equity in the company upon a triggering event. Assigning equity to SAFE investors will necessarily reduce, e.g., dilute, the equity of a founder. Because of the ease with which SAFEs can facilitate investment, the tendency for founders of start-up enterprises to rely on them can be a bit addictive, but the cost could be significant dilution of the founder’s own equity stake in their company. So, it is important to keep track of the investments derived from SAFEs and the terms of each SAFE. This is because a founder can theoretically cut different deals with different SAFE investors.
SAFE Triggers
One of the significant features of a SAFE that distinguishes it from outrightly awarding equity to an investor is that if the SAFE trigger never occurs, the investor’s right to equity pursuant to the SAFE may never be triggered. For the most part, triggers include the successful completion of capital rounds, or asset purchases, or an acquisition, events that can yield a share valuation, which is critical to ascertaining the amount of equity to which an investor is entitled. But even so, there can be variations of triggers. For example, while some SAFEs may only be triggered upon the completion of a Series A capital round, other SAFEs may only be triggered by a Series B or even Series C capital round or be restricted to an asset purchase or merger.
SAFEs are intended to be used by new enterprises structured as corporations
While it may be possible to structure a SAFE for a limited liability company (“LLC”), the Y Combinator model SAFEs assume that the offering entity will be structured as a standard corporation. This is because LLCs, which involve member interests, not shares, can make valuations challenging. The complexities involved in attracting LLC-specific investment has generally caused venture capitalists to want to convert LLCs into corporations in advance of raising capital.
For founders, thinking about what the corporate structure of their companies should look like, the general rule of thumb is to consider a standard corporate structure if the goal is to sell the company or take advantage of investment markets. On the other hand, LLCs are easier to set up and are more tax efficient because income flows directly to the owner, avoiding corporate taxation; standard corporations, by contrast, are taxed both at the corporate and shareholder level.
Most Favored Nation Clauses
Such clauses in SAFEs are intended to address the problem alluded to above, which is that, theoretically, the terms of a SAFE can vary from investor to investor, with some investors able to negotiate better terms, such as higher discount rates or lower valuation CAPs. To address this issue, it is not uncommon for investors to require a Most Favored Nation (“MFN”) clause to be included as a term of their SAFE. This clause typically provides that regardless the terms of the SAFE to which the parties have agreed, if the company enters into a SAFE with a second investor on the basis of more favorable terms, the first investor would be entitled to enjoy the same terms.
Where MFN clauses are at issue, founders must be especially diligent about keeping track of SAFE documents, since the final terms of a SAFE may, in fact, depend on the terms of another SAFE.
Exit Events
In addition to triggers, which entitle a SAFE investor to convert their investment into equity, a SAFE can also include “Exit Events” that can allow an investor to receive the return of their investment. For example, a change of control within the new enterprise could trigger an Exit Event entitling the SAFE investor to receive back the amount of their investment. Another Exit Event can be the dissolution of the enterprise itself. SAFEs can also provide that with respect to certain Exit Events, such as a dissolution, the return of the investment funds of SAFE Investors can have priority over the payment of other company debts.
Pre-money versus Post Money SAFEs
So far, we have been discussing Pre-Money SAFES based on a Valuation Cap. How much equity a SAFE investor is entitled to will depend on the number of shares sold and the valuation of the capital round, which has been designated a triggering event.
By contrast, a Post-Money SAFE guarantees the investor a certain percentage of the company’s equity after the completion of the triggering capital round. Some commentators have advised that while Pre-Money SAFEs are good when it comes to attracting multiple investors, Post-Money SAFEs may be better when it comes to dealing with a single, large investor. For the founder, the advantage of a Post-Money SAFE is that the amount of dilution that the founder can expect is determined even before the triggering event. On the other hand, with respect to Pre-Money SAFEs, the amount of dilution visited upon a founder depends on the outcome of the financing round.
The Takeaway:
SAFEs have emerged a significant vehicle for new enterprises to raise capital, but it is not an investment vehicle free from risk. To founders of Start-Up enterprises, the principal risk is dilution, i.e., the diminishment of the founder’s own equity stake in their company. Associated with this risk is the real problem of losing track of the amount of equity ceded by the founder and the terms of the SAFEs governing those investments. Y Combinator has formulated different versions of SAFEs to facilitate negotiations but there is still room to modify the terms of a SAFE, which means that it is still advisable to consult legal counsel who may be in the best position of not only ascertaining whether a SAFE is the best instrument to raise capital but how the terms of a SAFE could impact the fortunes of a founder.
Related content:
Part 1: Raising Money for Startup Enterprises. Enter the SAFE
Small Business Funding Options – Equity or Debt
