Start-Up Financing II
The SAFE - Highlighting Some Thorny Issues
In an earlier note we have introduced the Simple Agreement for Future Equity (the “SAFE”) as created by the famous American Start-Up incubator known as Y Combinator. When this note speaks of the standard SAFE model we mean the Post-Money SAFE as developed by Y Combinator. This is a widely used agreement in the United States for structuring a Start-Up’s Seed financing round. It is increasingly being used in the EU as well. In the earlier note, we described what the SAFE is and why investors like using it. I recommend you read that note for context prior to reading this one.
In this one, we will zoom in on some of the terms which are commonly found in the SAFE and which requires Founders to make some important decisions. Founders often simply download a standard SAFE template and use that one (such as the one available on the Y Combinator’s website). Don’t do that. Not all Seed investors are similar. Sometimes Seed investors are friends and family. Sometimes they are just ‘Founded-friendly’ for some other reason and may not require all the benefits offered to investors in the standard SAFE model. So you have to tailor your SAFE to your specific situation and not simply use what is online. This note will highlight some of the decisions the Founder needs to make when using the standard model SAFE.
Make sure your SAFE qualifies as equity and not debt
A SAFE is simply a pre-paid share purchase agreement. The investor will give you money today for a number of shares which you will have to give the investors later. The SAFE is meant to be an equity instrument and not debt. This means that the Start-Up should not include the SAFE as debt on its balance sheet but as equity. Be careful here. While the standard SAFE model may qualify as equity in the United States, this may not be the case in the country where you have incorporated your Start-Up. In the Netherlands for example, some argue that the standard SAFE model actually will more likely qualify as debt and not equity under Dutch law. This is in essence a tax law question and a founder acts prudently by consulting a tax advisor to make sure the company will not carry the SAFE as debt. One important factor which is relevant for the qualification of the SAFE funding as equity (at least in the Netherlands) is the absence of an obligation to repay the SAFE amount to the investor. Debt (loans) needs to be paid back and we do not want the SAFE to qualify as debt so you have to be mindful of this when you draw up your SAFE.
Triggering Events
An essential element in the standard SAFE model is the description of the so-called “conversion events”. These are the events which will trigger the SAFE investor’s right to receive his shares. I’m not a fan of the term “conversion event”. This conveys an impression that a debt is being turned into (converted into) shares when, in fact, we want to stay clear from terms which may assume the qualification of the SAFE as debt. There is conceptually no conversion taking place under the SAFE. The investor pre-paid for his shares and will simply receive his shares upon the occurrence of certain events. I prefer the term “triggering events”. When these events occur, they trigger the Start-Up to provide the investor his pre-paid shares.
Equity Financing as the Triggering Event - Should size matter?
The SAFE mentions an Equity Financing as the main triggering event. An Equity Financing is a transaction whereby the company issues equity (e.g. shares) to an investor in exchange for money. Interestingly, the standard SAFE model does not require the Equity Financing round to be of any particular size to trigger the obligation to provide the SAFE investor with his shares. It basically mandates this allocation of shares to the SAFE investor at the very next Equity Financing after the SAFE is entered into irrespective of the amount of money to be raised.
Founders should consider carefully whether this standard approach is right for their company. After your Seed round, you may have another relatively small equity funding round (perhaps as small as 25.000…) via the issuance of shares. Do you really want this small event to turn all your SAFE investors into shareholders and have to deal with all the rights which shareholders enjoy under law? All for a EUR 25.000,- funding round which perhaps only buys you a few extra months? If the nature of your relationship to your SAFE investors allows you to negotiate the triggering conditions, it is likely more in your interest to limit your triggering Equity Financing to qualified equity financing rounds of a certain minimum size. The ‘minimum size’ can pertain to either a minimum valuation amount of your company or the raising of a minimum amount of money (for instance requiring a raise of a minimum amount of EUR 1M for a qualified Equity Financing Event). This way you can have another small financing round to secure added funding without immediately turning your SAFE investors into actual shareholders.
Choose your SAFE holder’s type of equity carefully
Choosing the size of your triggering event is only one necessary decision a founder has to make. Another (more fundamental) decision is the type of equity instrument you would like to issue to your SAFE investor in case of an Equity Event. In line with common practice in the United States, the standard SAFE model requires the Start-Up to provide its SAFE investor with so-called ‘preferred shares’ upon the occurrence of an Equity Financing. It is also common for Start-Ups in the Netherlands to issue preferred shares to their Seed investors. However, your situation might be different. You might have investors who are close friends and family. Investors who may not necessarily require the issuance of preferred shares and who might be okay with a different (more Founder friendly) equity instrument. Do not just do what is common or written in a standard easily downloadable SAFE model. Always consider whether your specific situation provides you with a better option.
What are preferred shares anyway? Preferred shares are equity instruments which (pursuant to the articles of association) provide their holder with preferential (high rank) treatment in case of the distribution of dividends or exit proceeds. If there is money to distribute, it will first be paid to holders of preferred shares. They generally receive their initial investment back, increased by an agreed-upon interest or sometimes even a multiple (for example invested amount times two). If there is anything left afterwards, the remaining money will be distributed to the holders of ordinary shares on a pro rata basis. Though it is possible for holders of so-called ‘participating’ preferred shares to also (like ordinary shareholders) share in the distribution of this remaining excess profit, it is less common. Ordinary preferred shareholders generally just receive their investment back along with a premium.
A Founder should carefully consider whether he or she wants to issue preferred shares to SAFE investors. In principle, preferred shares include the right to vote and the right to attend meetings.. Perhaps, most annoyingly, a Founder will need approval from all shareholders (including preferred shareholders) for passing any resolutions outside of a formal General Meeting of Shareholders. Mindful that, in practice, the overwhelming majority of decisions are taken outside of a formal meeting of shareholders (i.e. simply by circulating a resolution for signing), a shareholders’ right of approval for ‘out-of-meeting decisionmaking can become very frustrating. A Founder should carefully consider the downsides before agreeing to issue (preferred) shares to anyone. It can significantly impact your freedom to govern your own company without interference. Issuing non-voting shares only goes so far. Non-voting shares include the right to attend shareholder meetings. Additionally, they include all other common shareholder rights such as the right to request the board for financial information etc.
In my view, the best option for Founders in The Netherlands (if they have the negotiating room) is to not provide their investor with shares at all but instead with so called ‘depositary receipts’ without meeting rights (certificaten van aandelen zonder vergaderrrechten). These are equity instruments which provide your investor with all of the financial benefits of ordinary shares but no voting rights and no rights to attend meetings. From a Founders’ perspective, they are great. They do require some added hassle to put them in place (a Dutch foundation needs to be incorporated to issue the Depositary Receipts to the shareholders), but this is easily done and generally worth the effort. Depositary Receipts
Liquidation Events
I like to finish with a word on the so-called Liquidation Events in the standard SAFE model. Liquidation Events under the standard SAFE (inter alia) relate to the sale of more than 50% of the equity (change of control events) as well as to a full on exit. The SAFE investor does not receive shares in a Liquidation Event but instead a sum of money as if he received the shares (generally the amount of money implied by a price per share resulting from the Post-Money Valuation Cap divided by the number of shares immediately prior to liquidation). Also on this point, a Founder should consider preferences. Do you prefer an obligation to pay money to your investors (like mandated by the standard SAFE) or to simply allow them to take shares immediately prior to the Liquidation Event? The answer can depend on various factors, including tax considerations which, against the background of qualifying the SAFE as equity, may prefer an issuance of shares over an obligation to pay back the funds.
For any legal assistance with structuring your (start-up) financing, reach out to marianne@starkslegal.nl.