In a previous article, we discussed what it means to raise capital through a Simple Agreement for Future Equity (“SAFE”). The SAFE was introduced in 2013, by Y Combinator (YC)1 and, has since been used by Startups as the main instrument for early-stage financing.
This article summarizes some key provisions which should be considered by the investors and Startups in the course of negotiating a SAFE. Some of these are highlighted below.
A. MATURITY DATE
SAFEs generally do not have a fixed maturity date for investors to recoup. Therefore, investments only yield returns when there is an occurrence of a triggering event, such as a liquidation, merger, future priced round, etc. In view of this fact, there are generally four (4) provisions which determine the returns on investment of a SAFE investor. They are:
i. Discount, No Valuation Cap;
ii. Valuation Cap, No Discount;
iii. Valuation Cap and a Discount; and
iv. Most Favored Nations (MFN) No discount; No Valuation Cap.
B. DISCOUNT, NO VALUATION CAP
A SAFE with a discount rate gives an investor a bonus for investing in the Startup at its early stage by providing a discount on the price of the investor’s shares when such shares are valued during a subsequent priced round. This is done with the belief that the shares of the Startup will increase in value and be sold at a higher price to future investors. When this occurs, the earlier investor is entitled to have his shares converted at a lower rate than future investors.
A practical example is as follows: Investor A gives the Startup N10,000,000 and the SAFE specifies that the investment is subject to a 50% discount. By implication, Investor A will be entitled to purchase shares from the Startup at a 50% discount from the price sold to other investors at the subsequent priced round. Therefore, if the Startup later sells at N2 per share, Investor A’s investment will convert to shares at N1 per share (50% off).
C. VALUATION CAP, NO DISCOUNT
While a discount offers investors a percentage off, a valuation cap imposes a limit on the value of the shares of the Startup by setting a maximum value of the shares of the Startup at which an earlier investor’s SAFE will convert to shares. Simply put, it is a renegotiated amount stated in the SAFE at which the early investor will purchase the Startup’s shares in the future notwithstanding where the value of the shares has increased beyond the “Cap”. This protects an early investor where the company’s worth skyrockets.2>
For example, where the SAFE sets an investor’s valuation cap at N50,000,000 and the Startup subsequently raises funds when it is valued at N100,000,000, the early investor will be entitled to convert his SAFE at a share price equivalent to N50,000,000, as if the Startup was valued at that Cap. Investors would, therefore, typically negotiate a lower cap compared to a higher one as it offers them a higher percentage ownership in the Startup.
D. VALUATION CAP AND A DISCOUNT
Some SAFEs have both a valuation cap and a discount. If this is the case, the investor’s shares will convert under the provision that offers a greater benefit for the investor. Although both provisions can be used in a SAFE, they cannot apply simultaneously to the benefit of the investor. Most investors prefer to have both a valuation cap and a discount as it provides them an option of choosing the terms upon which their shares will convert in the future.
E. MOST FAVORED NATION, NO CAP, NO DISCOUNT
Finally, it is possible to issue a SAFE with no valuation cap and no discount rate, but with a Most Favored Nation (MFN) provision. This implies that where the Startup subsequently issues another SAFE with more advantageous provisions to a future investor, the earlier investor will be entitled to the same benefits of the later SAFE. It is worthy of note, however, that an MFN provision only offers a single opportunity to amend the provisions of the SAFE except, the later SAFE also includes an MFN provision.
SAFEs are flexible and generally easier to negotiate compared to other forms of financing. It is important to note, however, that a SAFE does not guarantee the conversion of an investor’s equity in a startup. Despite the identified triggers for conversion of the SAFE, there may be scenarios where the triggers do not occur and the SAFE is not converted leaving the investor with less than his investment.
2 WHAT PURPOSE DOES “VALUATION CAP” SERVE IN A SIMPLE AGREEMENT FOR FUTURE EQUITY?
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.