From the issues that have to be negotiated when making an investment in a startup one certainly falls into a class of its own. It is agreeing on a valuation of the company. Taking this matter off the table, or rather postponing it to some future date, can make the negotiations much smoother.
To avoid the valuation debate there is an option to structure the investment either as a convertible loan or as a SAFE. While most or us can imagine what a convertible loan is and how it works, SAFE is a relatively new instrument. It has been developed by Y Combinator, a technology startup accelerator, in 2013 and stands for a Simple Agreement For future Equity.
SAFE is neither debt, nor equity. It converts to equity either at a next equity funding round or at a liquidation event. As counterintuitive as it may sound but a sale of the company also counts as a liquidation event.
Despite some similarities (both are simple and flexible) to a convertible loan SAFE is different in two important aspects:
– SAFE has no fixed maturity date, so there is no repayment obligation. The instrument remains outstanding until the next funding round or a liquidation event when it gets converted into equity.
– it has no interest accruing. The amount of investment remains unchanged with all the benefits to investor coming from the negotiated features of the instrument.
Parties to the investment transaction can choose the most appropriate structure from the four available types of SAFE:
– valuation cap only; no discount rate — establishing the maximum value at which SAFE will get converted irrespective of how high the valuation could be at the next equity financing round.
– discount rate only; no valuation cap — setting a discount to the valuation at which the equity investors will invest in the company at a later stage.
– valuation cap and discount rate — leaving the investor with a right to decide which one to use upon conversion.
– “most favoured nation clause” — with no valuation cap and no discount rate agreed, the conversion terms will be based on the most favourable terms offered to investors in the next equity round.
Some of the issues that need to be considered before deciding to use SAFE:
– SAFE may take a long time to convert. With no interest accruing the pressure on the company to raise an equity round is significantly lower. The management
– when an investor has agreed to the type of SAFE with just a valuation cap there is a possible scenario when the deal for a SAFE holder may not be better than for later investors. For example, the valuation cap has been set at EUR 5 million but the equity financing round takes place at a lower valuation of EUR 4 million.
– there will be no interest earned on the investment which adds to the cost of investment, especially in cases when the holding period is long.
SAFE is an instrument designed to make investment process smoother, faster and with less friction. It resonates well with the quote attributed to Paul Samuelson, the famous American economist: “Investing should be more like watching paint dry, or watching grass grow. If you want excitement, take USD 800 and go to Las Vegas”.
This note was first published on Medium.com on 23 October 2023.
