Start-Up Financing I - What is a SAFE and why does your investor want it?
Often some new cool thing starts getting popular in the United States and later on starts gaining traction in Europe as well. Within the realm of Start-Up financing, this happened with the SAFE, i.e. the Simple Agreement for Future Equity (the “SAFE”) as developed by the famous American incubator Y Combinator. The SAFE is an agreement between a Start-Up and its Seed investors and sets out the terms under which the Seed investors are willing to invest money in the startup. It boils down to this: the Seed investor will give the Start-Up money (on or around the date of signing the SAFE) and, in exchange for that money, the Start-Up promises to provide the SAFE investor with shares at a later date. The SAFE is a de facto pre-paid share purchase agreement. This is important to realize because it helps you understand what the SAFE is not. It is not a convertible loan agreement, whereby the investor lends the Start-Up company some money and has the right to later on convert the Start-Up’s debt into shares or ask for the money back. That is not what happens under a SAFE. The SAFE is an instrument of equity and not debt. There is no debt conversion taking place with a SAFE. The SAFE consists simply of a payment in advance for future shares. I buy and pay for my shares today but you deliver them to me at a later date.
The Post-Money SAFE is Equity and not Debt
There is an upside for Start-Ups in having their funding structured as equity and not debt. Start-Ups will have to account for their funding in their yearly accounts. So how do you book the SAFE in your accounts? Since (if structured properly) it is an equity instrument and not a debt instrument, a Start-Up does not need to register the SAFE as a loan which is beneficial for the company’s books and solvency. For the investor there is an obvious downside in the qualification as equity and not debt. In case of a liquidation event, debt holders rank higher than equity holders. So if there is money to be distributed, it will first go to the debt holder and only afterwards (if there is anything left) will money be paid to holders of equity.
A Simple Funding instrument?
The SAFE is an agreement that is often pitched to founders as a ‘simple’ way to raise funds (it's even mentioned in the name). I don’t fully agree with the pitched simplicity. Yes, in terms of process, the SAFE offers a simple path to money. However, the terms applied in the common SAFE are (in my opinion) not simple at all and a Founder acts prudently by making sure he diligently understands the terms he will be signing up to. Think of matters such as: preferred shares, conversions at (qualified or non qualified) equity financing rounds, liquidation events and liquidation preference clauses. Libraries have been written about each of these concepts so they are not easy and should be examined with care before signing.
The process towards signing a SAFE at a Seed round is indeed relatively easy compared to contractual instruments commonly used during a Series A or B financing. There is very little to negotiate. Usually, the most vexing matter to agree on with your investors is the valuation of your company. Especially in the early Seed stage (with little to no sales) it will prove difficult to properly value your company. The SAFE rids you of this exercise. No valuation will be required. Furthermore, all the annoying matters that you have to mull over when concluding a convertible loan agreement (such as an interest rate or a maturity date) are also not in play.
The lack of maturity date is often a very relaxing factor for founders. After all, if there is an ultimate date on which you may have to pay the investor back upon demand, then you will be on the clock and under pressure to achieve your Series A financing round before the dreaded maturity date arrives. The SAFE takes this pressure away. You can take as long as you want on your way to your first priced equity financing round. Just bear in mind that this may be relaxing for you but it's not that nice for your SAFE investor who may have to wait years before he sees that first Series A financing round and can receive his equity. Because of this added risk (as well as the usual risk of stepping in at such an early stage with many unknowns), the investor wants and receives certain benefits under the SAFE that ordinary investors do not get.
There are only two items that you need to agree on with your Seed investor prior to entering into the SAFE agreement: the (i) purchase price (i.e. the amount of money that the SAFE investor will pay you now in exchange for the future shares); and (ii) the so called Post-Money Valuation Cap. On a side note, once you have these two items figured out, you will also know the approximate size of the holding which your Seed investor will own. For instance, a Seed investor putting in EUR 1 million on a EUR 5 million Post-Money Valuation Cap will want to own (1/5) 20% of the (post-money) share capital of the company. Note that this will be ‘post’ other SAFE holders (or similar agreements) but not post the Series A Equity Round. The SAFE investor will dilute once the Series A investors come on board. Due to this potential dilution, the SAFE investor will not be able to identify his future holding with certainty but with acceptable precision.
The Post-Money Valuation Cap and the Discount
The main upside offered to investors under a SAFE is the use of an agreed Post-Money Valuation Cap. This is the maximum valuation of the company at which the SAFE investor must be provided his (pre-purchased) shares. The upside kicks in when the company does well and achieves a high valuation during its Series A financing round. The Investor’s capped valuation then leads to a comparatively low (fictional) share price. This will translate his pre-paid purchase price into a larger number of shares than he would have had if he had to apply the actual share price as used by the Series A investor.
Let's illustrate this with an example. Assume the company has 100 thousand outstanding shares and your Seed investor pays EUR 100 thousand under a SAFE with a post-money valuation-cap of EUR 1 million (this assumes a 10% ownership immediately prior to the Series A financing). Now assume that the Series A financing round occurs and the Series A investors are putting in EUR 500 thousand on a pre-money valuation of EUR 5 million. To figure out (on a pre-money basis, i.e. pre-Series A closing) how many shares the start-up needs to provide the Series A investor, you have to divide the investment amount (EUR 500 thousand) by the price per share during the Series A financing. There are 100 thousand shares in circulation at the time, making up a valuation of EUR 5 million. So the price per share for the investor is 50 euro per share. Since the Series A investor is putting in EUR 500 thousand, this means you have to give your Series A investor a total of 10.000 shares.
Note that we are using a pre (Series A) basis here and that this number will change when viewed under a post (Series A) basis. We are doing it this way because the SAFE investor’s Post-Money Valuation Cap pertains to the same stage, i.e the post (Seed) money but pre Series A money stage. This helps the comparison.
How many shares do you have to give your seed investor under the SAFE? The SAFE capped the valuation at EUR 1 million. Even though the company is valued at 5 million during the Series A round, the SAFE investor will receive his (pre-purchased) shares at a valuation of EUR 1M. The price per share for the seed investors will therefore be EUR 1 million divided by the number of issued shares (100.000) which equals EUR 10 euro per share. Since the SAFE investor put in EUR 100.000,- he will acquire the same number of 10.000 shares as the Series A investor (100.000/10) but at the lower price of EUR 10,- per share as opposed to the EUR 50,- that the Series A investor will have to pay. This is the great upside of the post-money valuation cap. It can result in a significant reduction on the price per share and compensate the SAFE investor for funding the start-up at its earliest stage.
The above example assumed the Series A valuation was higher than the agreed valuation cap. What if that is not the case? What if the Post-Money Valuation Cap set by the SAFE investor is EUR 1M but the Series A valuation is EUR 750.000,-? This can happen when the Seed investor over-enthusiastically sets a too high cap. In such a case, the SAFE allows its holder to simply step in at the same price per share as the Series A investor. A standard SAFE commonly gives you the choice to use the price per share (between the one implied by the valuation cap or by the actual valuation) which leads to the greater number of shares.
Discount
There is another benefit which SAFEs commonly provide their holders either as an alternative to the Post-Money Valuation Cap or in addition to it. In my experience, it's not that common to give the SAFE holder the benefit of both the valuation cap and the discount but it's definitely possible.
Remember that seed investors want mechanisms in place to get their shares at a relatively (relative to the Series A investor) low price to compensate them for the larger risk they are taking by stepping in so early. We have illustrated how the Post-Money Valuation Cap results in a relatively low share price for the Seed investor. The ‘discount’ mechanism is much more straightforward and simple. In short, this benefit simply means that the SAFE investor and the start-up will agree on a discount on the share price at the Series A financing round. The discount will commonly be set at (or around) 20%. So if the Series A investor purchases shares at EUR 1- per share, the SAFE investor will receive his (pre-paid) shares for EUR 0,80 per share. Very straightforward. This mechanism makes the SAFE even easier for the parties. After all, then you don’t even have to think about setting a Post-Money Valuation Cap.
I hope this note gave you some more insight into the workings of the SAFE and why it has become so popular among investors. In a separate note I will discuss the terms of the SAFE on a more granular level so that founders understand their options and the choices they will have to make. After reading that one, you will see that the SAFE, on its content, isn't that simple at all.
For any legal assistance with structuring your (start-up) financing, reach out to marianne@starkslegal.nl.