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In a changing startup economy, the Simple Agreement for Future Equity (SAFE) note has become a popular fundraising vehicle for startups in their capital-raising journey. Startup owners tend to leverage the flexibility of the SAFE to prevent placing a lower valuation on their company and avoid the negative consequences associated with a down-round. However, trends in the current market show that including new terms in SAFEs can reduce your investor’s risk exposure. This article will cover these new clauses and why investors increasingly want to include them in SAFE raises.
What Are SAFEs?
SAFE stands for ‘Simple Agreement for Future Equity’. Under a SAFE, an investor provides your startup with cash. In return, your company promises to issue shares to the investor as part of its next priced equity raise at a discounted price.
Usually, if you do not raise more equity, the SAFE will not convert. As a result, the investor’s right to receive shares will continue until:
- you eventually raise money; or
- your company goes insolvent.
What Are the Benefits of Using SAFEs?
One of the key attractions of using a SAFE note is the ability to delay putting a valuation on your company. If your company relies on equity funding, your valuation must be higher than the previous valuation of each subsequent raise. However, if your valuation is lower, then you will have what is known as a “down round”.
Hence, SAFEs allow you to:
- delay placing a valuation on the company; and
- avoid achieving a down-round.
The LegalVision Startup Manual provides guidance on a number of common challenges faced by startup founders including structuring, raising capital, building a team, dealing with customers and suppliers, and protecting intellectual property.
The guide includes 10 case studies featuring Australia’s top VC fund partners and leading Australian startups.
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What Terms Can Reduce Investor’s Risk Exposure?
There are a few terms in SAFEs that can reduce your investor’s risk of exposure.
Suppose your company becomes insolvent, and the SAFE is still outstanding (i.e. has not converted into shares). In this instance, your SAFE investors will be unsecured creditors who are entitled to repayment ahead of any shareholders.
Consequently, some investors may try to amend a SAFE’s insolvency clause by granting themselves the ability to trigger repayment of the SAFE if the investor suspects the company is going insolvent.
Nevertheless, it is essential to review any amendments to a SAFE’s insolvency clause to ensure investors cannot exploit it by demanding repayment too early in time.
While maturity dates are conventionally found in convertible notes, investors have increasingly requested maturity dates in SAFEs. A maturity date refers to when the SAFE must convert into shares where you have not raised equity by a specified date.
Maturity dates make SAFEs more like convertible notes. For example, at the maturity date, the convertible note must either be converted into shares or repaid in cash. However, unlike a convertible note, a maturity date in a SAFE will only trigger a conversion into shares and not a cash repayment.
Ultimately, maturity dates in SAFEs are becoming more frequent since, in the current economic climate, investors are less confident that a priced equity raise will happen. If a priced equity raise does not occur, this means the SAFE does not convert into shares for investors.
Pre-Money vs Post-Money SAFEs
Previously, it was more common to encounter pre-money SAFEs. A pre-money SAFE is where its value is excluded from the definition of fully diluted. For example, say your SAFE has a valuation cap which is lower than the valuation of the company at your next raise. In this instance, when your SAFE converts the number of shares issued to the SAFE investor, the conversion will be based on the valuation cap specified.
On the other hand, a post-money SAFE is where its value is included in the definition of fully diluted. In the current climate, there has been a swing towards post-money SAFEs. This is because post-money SAFEs provide an investor with certainty over what its percentage holding will be immediately before your company’s equity raise, regardless of the amount of capital your company has raised prior to issuing the SAFE.
Variable Discount Rates and Valuation Caps
Traditionally, discount rates and valuation caps are fixed values. Whilst still fairly uncommon, there has been a small uptick in variable discount rates and valuation caps. This concept involves making the discount rate or valuation cap more favourable to the investor if the SAFE does not convert on set dates.
An increasing discount reflects the risk that SAFE investors have undertaken by investing in your company earlier than the later equity investors. However, you need to consider the impact of these discounts on your existing shareholders, including yourself. After all, the higher the discount, the more dilution for your existing shareholders when the SAFE converts.
What Impact Can These Clauses Have on Your Company?
Before accepting a valuation cap or a maturity date in your SAFE, you need to consider its impact on your company. If your valuation cap is set too low, you will be heavily diluted when the SAFE converts. Moreover, if you include a maturity date, the SAFE holder will eventually become a shareholder in your company. Hence, you should ask yourself, ‘is this a desirable outcome if you have not managed to complete an equity raise?’
Companies with inflated valuations often use SAFEs to defer the risk of a down-round. In this context, investors often take the view that founders must bear the ultimate risk of raising capital in uncertain times. However, you need to ensure that the terms you agree to will not hamstring your company’s future performance. In other words, do not let your SAFE become too unsafe!
A Simple Agreement for Future Equity, or SAFE, remains an excellent option for:
- raising capital for early-stage startups; or
- bridging finance between capital raises.
However, in an attempt to minimise their risk, investors have sought terms in SAFEs relating to insolvency, maturity dates, post-money valuations and variable discount rates. Hence, it is important to understand what these terms are and the motivation behind your investor wanting to include them.
If you have any concerns about an unsafe SAFE, please get in touch with our experienced capital raising lawyers, who can assist as part of our LegalVision membership. You will have unlimited access to lawyers to answer your questions and draft and review your documents for a low monthly fee. Call us today on 1300 544 755 or visit our membership page.
Frequently Asked Questions
As a founder, your shares normally represent what is known as “sweat equity”. Since you have put considerable effort into growing your business, you should profit from the value of your shares in the event that you sell your business or list it on a public exchange. The main implication of an insolvency clause is that founders receive the lowest rank when it comes to repayment from assets in an insolvency or liquidation event. Hence, there might not be enough money to repay the founders and ordinary shareholders once all creditors and preferrence shareholders are repaid from the asset sale.
A SAFE will only allow the conversion into shares when a trigger event arises. On the other hand, convertible notes typically allow either conversion into shares or repayment with interest.
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