Using Simple Agreement for Future Equity or SAFEs has emerged as a major funding vehicle for start-ups but it is not a funding vehicle free from risk.
Let’s look at a financing senario…Pedro has been working on a gaming program that uses Artificial Intelligence to allow his gamers to explore a potentially infinite number of unique storylines. The game, “Poncho,” has attracted a lot of interest. Several companies have approached Pedro to discuss options to buy into his company, “Gamer Alert.”
The potential investing companies floated two main ideas to Pedro:
Option 1: They could simply buy shares in his company or
Option 2: They would loan him money based on convertible notes, which would be debt that could be converted into equity should Gamer Alert undergo a Series A round of financing.
Pedro saw problems with each of these approaches. First, if Gamer Alert were to issue equity, how much would that amount to? Investor 1 wants to invest $500,000 in Gamer Alert, but how can the shares be valued and how much equity would be left for Pedro? Pedro could see that the issue of share valuation could become complicated and controversial since Gamer Alert was not on a stock exchange and so there was no way of easily determining the fair market value of its shares.
Investor 2 was also interested in investing $500,000, but in convertible debt, which would allow Investor 2 to convert the debt into shares upon the occurrence of certain triggering events, like the completion of a financing round. This was a more attractive option because the issue of share valuation could be sidestepped. The problem was that Investor 2 insisted that because it was loaning money to Gamer Alert it should be paid interest in the amount of 4% annually. Since his company was barely able to keep the lights on as it was, Pedro feared that paying interest could end up draining the financial resources of Gamer Alert, sinking the enterprise before it even got started.
Seeking other options, Pedro decided to pay a visit to his trusted attorney, Saul Goodman (who, of course, knows everything). Saul had the following insight:
A different form of financing was invented in 2013 by one of the largest tech-incubators—Y Combinator. The objective of Y Combinator was to produce a standard form agreement that would facilitate investment without the parties having to value stock and negotiate terms of sale. Calling it a “Simple Agreement for Future Equity” or “SAFE,” Y Combinator framed a series of agreements, covering slightly different situations, which would allow an investor to invest a certain amount of money in an enterprise in consideration for the right to convert its investment, upon the occurrence of specified triggering events, into shares based on a pre-negotiated valuation; find out more more here. For early SAFE investors, they might also receive a discount of 10-20% off the share price assessed at the time of the prescribed financing.
For parties like Gamer Alert, the advantage of a SAFE was that the actual equity valuation could wait until a designated capital round at which point the market price for the shares would be determined. Because a SAFE is not a convertible note, Gamer Alert would not need to pay interest. For the would-be investor, the SAFE also had some material advantages. First, legal costs could be kept to a minimum. Second, a more modest SAFE investment could yield a potentially large equity share if a capital round went well. In terms of mechanics, the two most important terms of a SAFE are the valuation cap agreed to by the parties, which is a predetermined maximum valuation at which the investor’s SAFE would convert into equity, and the discount rate, meaning the discounted share price should the capital round raise funds at or below the valuation cap).
Example: An investor agrees to invest $1 million in an enterprise in consideration for the right to convert the investment to equity upon the completion of a Series A capital round. The investor and enterprise agree to a $10 million valuation cap and a discount rate of 20% (meaning that the investor would be able to convert its investment at 80% of the share price determined by the capital round should the capital round raise funds at or below the valuation cap).
Two years later
Two years later, the company initiates a Series A capital round which yields the enterprise $20 million, based on the sale of 20 million shares priced at $1.00 per share. Because the capital round raised funds exceeding the $10 million cap valuation, the investor can convert their investment into equity at a $10 million valuation based on the price of $0.50 per share ($10 million /20 million shares), affording the investor 2.0 million shares. If the enterprise is valued at (or below) the valuation cap of $10 million, assuming a price of $1.00 per share and the sale of 20 million shares, the investor would receive a 20% discount, which would allow the investor to convert its investment to equity at 80% of the per share price or $0.80 per share, yielding the investor 1.25 million shares.
Key to the ability of the investor to convert its investment into equity are the events that can trigger a conversion, such as the completion of a capital round, or a liquidation involving the enterprise being purchased by another entity. If such triggering events never occur, however, the investor may never have the right to convert its SAFE into equity. The main risk for the founder is that the ability of investors to convert their investments into equity could end up severely diluting the founder’s own equity in the enterprise.
Pedro said that using a SAFE was a good idea but raised several issues, such is as how valuation caps should be determined and the significance of such caps in terms of potentially diluting the equity stake of founders, post-money versus pre-money valuations, the significance of pro rata rights, and other issues we should consider also, in our next article.
The Takeaway.
Since 2013, founders of technology companies have used SAFEs as vehicles to raise funds. The rationale behind using a Simple Agreement for Future Equity is to minimize the costs and complications involved in negotiating investment contracts. Using SAFEs has emerged as a major funding vehicle for start-ups but it is not a funding vehicle free from risk.
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Small Business Funding Options – Equity or Debt
