Simple Agreements for Future Equity (SAFEs) have become a popular capital raising tool for companies and in particular, start-ups, since their inception a decade ago. Although designed to enable companies access to early-stage capital without the complexity of traditional debt and equity mechanics, SAFEs can often prove to be a far-cry from “simple”, as the name would suggest.
We explore some of the key factors relevant when considering whether to issue SAFEs, as well as some of the potential pitfalls to avoid.
What are SAFEs and why are they so appealing to start-ups?
A SAFE note is a short-form agreement between a company and investors whereby the investor makes a cash contribution in exchange for equity in the company on the occurrence of certain trigger events in the future, including a subsequent equity raising or sale. Distinct from standard debt or equity capital, SAFEs do not typically have a set maturity date, no interest is payable on their issuance, and founders do not immediately give up equity to investors.
The Australian Investment Counsel (AIC) provides a template SAFE which is commonly accepted in the Australian market as the standardised form. This allows companies a key reference point when negotiating the few variables in a SAFE which are left for negotiation.
Such simplicity and uniformity means that SAFEs have the potential to streamline the investment process, allowing start-ups quicker access to capital with fewer legal hurdles. For investors, SAFEs provide an opportunity to access equity early and on favourable terms, with the benefit of discounts and valuation caps providing a potential return commensurate with an early-stage investment.
Key SAFE mechanics
When determining the number of shares an investor will be issued upon conversion of a SAFE, the conversion is typically based on:
- the investment amount divided by the Discount Price; and/or
- the investment amount divided by the Cap Price.
SAFE Notes can utilize either a Discount Price, Cap Price or both mechanisms (where whichever results in the greatest number of shares being issued to the SAFE holder is used).
Both the Discount Price and the Cap Price are discussed in further detail below and, while the AIC template SAFE contains provisions for the inclusion of both concepts, SAFEs can be tailored to include one or the other.
Discount Rate and Discount Price
The discount rate is the discount applied to the price per share paid in relation to Qualifying Financing in determining the price used to convert the SAFE into shares. For example, if the price per share payable by the incoming investor in a Qualifying Financing is $10 per share, and the SAFE specifies a discount of 10% will apply on conversion of the SAFE, the SAFE investor will be issued the same class of shares at a price of $9 per share.
This price is referred to as the Discount Price.
Valuation cap
This figure reflects the maximum value of the company to be applied when calculating the SAFE conversion price on a Qualifying Financing. It acts as an anti-dilution mechanic in favour of the investor by setting a floor on the proportion of equity the investor will receive following conversion.
The valuation cap is used to determine the Cap Price, which is calculated by dividing the valuation cap by the fully diluted capital of the company. However, determining the fully diluted capital is a concept the subject of variability in both the US and the Australian market.
The AIC has recently updated its template SAFE to reflect a “post-money SAFE” rather than a “pre-money SAFE”. This means that the Cap Price is calculated by reference to the fully diluted capital of the company, including by reference to the number of shares that would be issued following the conversion of the SAFE. This is in contrast to a pre-money SAFE, which calculates the fully diluted capital exclusive of the shares issued on conversion of the SAFE and any other SAFEs (and depending on the vintage of the SAFE template, may also exclude any convertible notes).
Qualifying Financing
The most common trigger resulting in the SAFE converting into shares is a future equity fundraising event (or series of related events) through the issue of new shares. A minimum round size is typically specified, rather than any financing event automatically triggering conversion (e.g. the SAFE will only convert into shares where the company raises at least $5 million).
This is commonly referred to in SAFEs as a Qualifying Financing.
SAFE mechanics in practice
Example 1
Consider the below example where a SAFE includes the following:
- Initial investment: $10,000
- Qualifying Financing: $1,000,000
- Discount: 10%
- Discount Rate: (1 – Discount) = 90%
- Valuation Cap: $2,500,000
- Post-money fully diluted capital: 1,000,000 securities
Using the above metrics, assuming the company issued $1,000,000 of new Class A shares at a price per share of $2 per share, the investor under the SAFE will be entitled to the higher of:
(a) Initial investment / (price per share payable on the Qualifying Financing x Discount Rate)
$10,000 / ($2 per share x 0.9) = 5,556 Class A shares
OR
(b) Initial investment / (Cap Price (being equal to Valuation Cap / Post-money fully diluted capital))
$10,000 / (2,500,000 / 1,000,000) = 4,000 Class A shares
In the above example, the Discount Rate provides the investor with a higher number of shares following conversion. Therefore, the SAFE will convert into 5,556 Class A shares.
Example 2
Consider a revised example, whereby the Valuation Cap is now $1,700,000.
Using the above metrics, assuming the company issued $1,000,000 of new Class A shares at a price per share of $2 per share, the investor under the SAFE will be entitled to the higher of:
(c) Initial investment / (price per share payable on the Qualifying Financing x Discount Rate)
$10,000 / ($2 per share x 0.9) = 5,556 Class A shares
OR
(d) Initial investment / (Cap Price (being equal to Valuation Cap / Post-money fully diluted capital))
$10,000 / (1,700,000 / 1,000,000) = 5,882 Class A shares
In this example, the lower Valuation Cap results in a higher number of shares being issued to the investor on conversion of the SAFE.
Navigating the Challenges: Understanding Common Pitfalls
Although SAFEs are an efficient means of raising capital given they are based on a commonly used template requiring little negotiation, the conversion of many SAFEs to shares in the last five years have given rise to a number of unintended consequences. It is important for both companies and investors to be aware of these consequences when entering into a SAFE.
1. Impact of the SAFEs on Conversion
It is important for investors and founders to be aware of the dilutive impact of the conversion of SAFEs upon a subsequent equity round. If incoming investors are subscribing for shares based on an agreed enterprise value, it is important to take into account the conversion of the SAFEs when analysing the post-money shareholding of the investor to ensure it is consistent with their expectations. Otherwise, investors run the risk of receiving a significantly reduced proportion of the share capital than what they expected.
2. Unanticipated Equity Class Conversion
A SAFE will typically convert into the same class of shares that are issued during the Qualifying Financing. For example, if a company offers Class A shares with preferential rights to attract large, institutional investors, all SAFE holders will receive Class A shares on conversion and enjoy the same preferential terms. This scenario can lead to a dilution of rights and potential discontent among both new and existing shareholders. It may also result in minority shareholders having disproportionate rights relative to their investment.
3. Pre-money or Post-money SAFE
As we explain above, the Cap Price may be determined by reference to the fully diluted capital in the company either taking into account, or excluding, the shares which are issued on conversion of the SAFE. This can be particularly problematic where the company has multiple SAFEs issued at different times, as the standardised form of SAFE has shifted from pre-money to post-money (or in some cases, does not clearly articulate the calculation methodology relevant to the company’s capitalisation).
4. Consistency of terms and the importance of the cap table
To the extent possible, it is advisable for companies to negotiate the same terms across all SAFEs in a particular round. In particular, ensuring SAFEs are either all pre-money or all post-money SAFEs, the Valuation Cap is consistent, and the applicable Discount Rate is consistent. It is also preferable not to raise multiple SAFE rounds on different terms. This makes it difficult to model the dilution impact in future equity rounds.
In practice, this is a difficult task, as different investors may negotiate varying terms in their respective SAFEs. Therefore, it is imperative that the company maintains a sophisticated and up-to-date capitalisation table. While the cap table will not be able to accurately reflect the dilutive impact of SAFEs until conversion (given the price per share on the occurrence of the Qualifying Financing will only be known at the relevant point in time), having a firm understanding of the Discount Rates and Valuation Caps which are applicable to all outstanding SAFEs on issue will enable the company to present this information to investors and to calculate their proportionate interest following the conclusion of the funding round.
Although not included in the AIC’s template SAFE, experienced venture capital investors may look to include investor-friendly provisions such as pro-rata rights, information rights, rights of first refusal and most-favoured nation clauses. While not uncommon, it is important for companies to always be cognisant of the impact these clauses may have and to track which investors have what rights available to them.
5. Anti-dilution adjustments
SAFEs also interact with existing shares on issue. If the company has already issued preference shares, particularly those which adopt anti-dilution provisions, this can complicate the capital structure further. If SAFEs convert at a lower price per share (as a result of a misguided valuation cap for example) to the price per share issued to preference shareholders, this may constitute a ‘down round’ pursuant to the preference share terms, triggering anti-dilution adjustments. This can lead to significant adjustments in the proportion of equity which is held by incoming investors on a fully-diluted basis.
6. Exceeding Shareholder Limits
A major risk with SAFEs is the potential to exceed the legal limit of 50 shareholders for private companies pursuant to the Corporations Act 2001 (Cth). This often happens when startups issue multiple SAFEs without considering how conversion on a Qualifying Financing will expand its shareholder base. This can push a company toward the complex regulatory environment applicable to public companies. Companies could consider including provisions in the SAFE requiring the investor to have their converted shares held by a bare nominee in order to avoid this pitfall.
Simple Agreements for Future Equity – not so ‘simple’ after all
Although intended to be simple, SAFEs can be fraught with complexities. It is important to understand the mechanics of a SAFE and to avoid the potential pitfalls which often befall those without proper guidance. If in doubt, keep it simple and issue shares instead!
For more information, please contact Peter Williams or Julian Ilett.
