You might be a founder working with developers on a new SaaS platform, insurtech product or other tech innovation. Or, you may be an investor looking to embark on your first adventure in the world of start-up investing. Either way, it is important to have a fundamental understanding of the different instruments which are used by start-ups to raise seed capital and the pros and cons of each.
The three options available to start-up founders to raise seed capital are:
- Simple agreement for future equity (or SAFE);
- Convertible Notes; and
- Priced equity round (i.e. standard share issue).
SAFEs were introduced to the start-up venture capital community in 2013 by Y Combinator in Silicon Valley. A SAFE was designed to be a standardized document that reduces transaction costs for early-stage financing (i.e. lawyers fees!). Notwithstanding its standardized nature, there are some key parameters and variables that are important to understand when raising capital under this document.
A SAFE is, in simple terms, an agreement under which funds are provided to the company, which are not converted into equity (shares) in the company until a trigger event occurs at some point in the future, usually being the next priced equity round (i.e. where the company undertakes another capital raising where a valuation is set, a price per share determined and shares issued to investors).
Unlike a convertible note, a SAFE is not debt and there is no interest payable by the company and no maturity date or repayment obligation. In this sense, it is a riskier proposition for an investor because they have no surety that the amount they pay to the company will ever convert into equity. To compensate the investor for accepting this risk, they are entitled to convert their capital contribution into shares at the time of the next qualifying priced equity round at a lower price than new investors. This price is usually at a fixed discount to the issue price (e.g. 20%) or based on a valuation cap (or whichever of these options results in the lower issue price and therefore most shares to be issued to the investor). A valuation cap fixes the maximum price per share which the SAFE investor’s contribution can be converted into shares in the priced equity round.
For example, if there were 1,000,000 shares on issue in the company and the SAFE set the valuation cap at $5 million and also included the option of a fixed discount of 20%, then the maximum price per share based on the valuation cap would be $5 per share. If the priced equity round was based on a pre-money valuation of $8m, shares could be issued to the SAFE investor at $5 based on the valuation cap (being a 37.5% discount to the $8 issue price for new investors) or $6.40 per share based on the fixed 20% discount. The SAFE investor will choose the lower price based on the valuation cap so that they receive more shares and therefore a greater proportion of the equity in the company.
Another key consideration for founders and investors is that SAFEs are typically ‘eligible venture capital investments’ for the purposes of the Income Tax Assessment Act 1997 (Cth), meaning Venture Capital Limited Partnerships (VCLPs) and Early Stage Venture Capital Limited Partnerships (ESVCLPs) can provide capital to start-ups under a SAFE instrument. This is not necessarily the case for all convertible notes (as discussed below).
Convertible notes are used in different phases of a company’s growth for different purposes but are most often used in early financing rounds. They are not based on a standardized template like a SAFE and therefore provide more flexibility for a founder and/or investor, depending on the circumstances.
The key difference between a convertible note and a SAFE, is that a convertible note (is generally a debt instrument for accounting purposes. Interest is generally payable on a convertible note and there is a maturity date by which a trigger event must have occurred so that the notes can convert to equity, or otherwise the company must repay the debt to investors.
As with a SAFE, the funds contributed will convert to equity upon a qualifying financing at a discount to the price set during the priced equity round, based either on a fixed discount and/or valuation cap.
Unlike a SAFE, which is recorded on a company’s balance sheet as equity, the amount owing to investors under a convertible note will generally sit on a company’s balance sheet as a liability. Therefore, founders need to be cognizant of the company’s obligations to repay noteholders and, where they are directors of the company, their duty to prevent insolvent trading.
The treatment of convertible notes for tax purposes can vary depending on the terms of the notes themselves. This is a critical issue for determining whether a VCLP or ESVCLP can invest through a convertible note because only convertible notes which are equity for tax purposes qualify as an eligible venture capital investment.
Priced equity round
Under a priced equity round, the company issues new shares to investors based on an agreed valuation and therefore fixed price per share. Investors receive shares upfront and the company then owes no further obligations (e.g. interest payments, trigger rights etc.) in addition to the usual obligations owed to shareholders under the law and any shareholders agreement in place.
A priced equity round is the simplest in terms of giving founders and investors a clear view on valuation and dilution. However, negotiations around valuation can be time consuming and there are additional complications which can arise where investors seek to negotiate additional rights under a shareholders agreement or side letter, such as pro-rata rights in future capital raisings, rights to appoint directors and drag-along and tag-along rights. This usually means that a priced equity round is slower to execute and is often the reason why start-ups opt for a SAFE or convertible note when the speed of execution and funding is a priority during the early stages of a start-up’s journey.
Which is best for a start-up or an investor?
There are pros and cons of each instrument from the perspective of both the company and an investor. Any approach should be tailored to the prevailing circumstances at the time.
In general terms, SAFEs are most useful in the very early stages of the company’s life when accurately valuing the company is usually very difficult – if not impossible. They are also quick and cheap to execute when the founders are strapped for cash. They can also be used multiple times for “mini rounds”, although founders should be cognizant of the dilutionary impacts of multiple SAFEs.
Convertible notes have similar characteristics to a SAFE and offer the same benefits of deferring valuation until a priced equity round, but convertible notes also give investors the additional benefit of interest and a fixed maturity date. Conversely, interest and a fixed maturity date can be disadvantageous for a start-up if it struggles to raise further capital and comes under pressure to repay the convertible notes on the maturity date (as opposed to a SAFE, which may never convert if a trigger event never occurs).
Priced equity rounds take longer to execute because the company and investors have to reach a consensus on valuation, the amount to be raised and other rights that may be granted to investors (e.g. under a shareholders agreement). The company is usually also dealing with multiple investors at once requesting different rights and different terms in the transaction documents.
The following table provides a summary of some of the key characteristics of each instrument.
|Priced Equity Round
|Equity or debt?
|Caps and discounts?
|Time to execute?
|Depends on terms
* Denotes that they are generally considered debt for accounting purposes but specialist advice should be sought to determine whether they are tax or equity for tax purposes and whether this has any impact on the anticipated tax benefits associated with the investment.
Finally, the most important thing that all founders and investors need is good advice! Although a SAFE is intended to be a standardized document, start-ups and advisors can (and do) amend some of the terms, so you should be careful to ensure you understand what you are signing up to.
Anyone issuing or subscribing for SAFEs, convertible notes or priced equity should work with a start-up mentor and/or qualified legal practitioner experienced in capital raising for start-ups to avoid unnecessary headaches down the track.
For more information, please contact Peter Williams.