As the popularity of the Simple Agreement for Future Equity (SAFE) begins to grow in Australia, many founders find themselves considering using a SAFE for their startups next raise. A SAFE is an easy, company-friendly way to raise capital. However, while there are strong arguments in favour of raising capital early or bridging rounds of capital via this mechanism, it is not without its shortfalls.
What is a SAFE?
A SAFE is a mechanism under which an investor provides funds to a startup in return for a right to convert their investment into shares in the company. The conversion will occur at specifically defined trigger events, generally an exit event or the startups next equity financing round.
A SAFE is an alternative to a convertible note, and unlike a convertible note, it is not a loan. It does not contain a termination or maturity date, and therefore if your startup does not make it to an exit or the raising of another round, the investor won’t get their investment back. Generally speaking, it is simple to negotiate. Further, as the key terms and mechanics of the investment are set out in the one or so page document (up until conversion), it is cheap to implement from a legal perspective. However, there are also many complexities to the SAFE agreement which may hamper its appeal.
While very common in the US thanks to efforts of their creator, Y Combinator, SAFEs are still relatively new in Australia. Many investors may have only ever heard of a SAFE and never actually invested via one. For this reason, you might find it harder to get an investment using a SAFE as opposed to a standard equity raise. Some investors perceive these documents as unfair or demonstrable of a lack of commitment by the startup and may be less willing to invest via a SAFE.
Including more complex terms
A major plus of the SAFE is that there is no need to set a share price at the time of the investment. This means that you can have an injection of capital in the crucial early days but avoid having to negotiate a valuation (and also avoid subsequent issues that can arise from trying to value a very young business). However, many investors will insist on the inclusion of a valuation cap within the SAFE. In effect, this means that you are agreeing on a future valuation of the company. A valuation cap protects the investor from the company raising their next round at a very high valuation and leaving the investor with only a small amount of ownership. Including a valuation cap will increase the negotiation time and the risk of the company valuing itself too low.
Prolonging the inevitable
A one document deal is a real plus for a startup without the luxuries of time and cash. However, once the SAFE converts, the company will need a Shareholders Agreement as well as all documents required to issue the shares to the SAFE holder. Future problems may also arise when the SAFE holder becomes a shareholder and has to agree to be bound by a Shareholders Agreement, something they didn’t foresee upon their initial investment.
A Shareholders Agreement is an extremely important document that governs the investor’s relationship with the company and other shareholders. It is important that everyone is on the same page when it comes to decision making, board representation etc. If the company and investor relationship is strong and aligned this shouldn’t be an issue, but this isn’t always the case.
Incentive to succeed
Having no maturity date or interest component makes the SAFE a flexible instrument for the company. However, some investors argue that the lack of these terms means that the company has no incentive to close an equity round or achieve an exit. A push from an interest rate or an upcoming maturity could be just what the startup needs to achieve its next milestone.
A bona fide round?
Some SAFE agreements will require that the qualifying round at which the SAFE note converts must be a bona fide round. Meaning, a genuine capital raise. However, there is no need to agree on the size of the round within the SAFE. The company could raise a very small round at an overblown valuation and the SAFE holder will convert for less than what they otherwise might have, had the round been larger and therefore more hotly negotiated between the parties.
A well thought out SAFE which strikes a fair deal between company and investor is a great way for an early stage startup to raise capital. However, an investor or founders unfamiliarity with the mechanism, a high-risk investment, and/or unfair and complex terms, all have the potential to quickly turn what may have been a simple agreement into something different entirely. If you have any questions about SAFEs or need advice when raising capital for your startup get in touch with LegalVision’s Startup lawyers on 1300 544 755.
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