One common problem of early-stage ventures is the difficulty in determining a company valuation when recruiting capital from investors. This problem derives from the tension between entrepreneurs’ desire for a high valuation (in order to avoid significant dilution) and investors’ desire for a low valuation (in order to increase their holding ratios). This problem naturally becomes even more acute for startups since it is very difficult to assess their commercial success in the future. On the one hand, startups may have high growth potential (scalability). On the other hand, they may face numerous challenges that limit or thwart their success. An entrepreneur and investor looking to sign an investment agreement may reach a dead end if they are unable to agree on the company’s valuation. Setting the wrong company valuation during the first round of funding could make it very difficult for the venture to raise capital during subsequent rounds.
Taking the SAFE Route
A SAFE (Simple Agreement for Future Equity) is a short agreement designed to alleviate tension between the parties and protect both parties from uncertainty over the venture’s value during its fledgling stage. This is a “standard” agreement initially drafted by one of the leading American investment funds in the world, Ycombinator, in collaboration with numerous startups.
A SAFE is a popular instrument for raising capital among early-stage startups. Essentially, in a SAFE, the investor injects capital into the company in the present, while determining the number of shares and percentages the investor will receive in the future (during the next investment in the company).
Under a SAFE, the entrepreneur receives the money immediately from the investor, without agreeing on the company’s value. Only at a later stage, when the venture raises more significant funding from a new investor, will the new investor determine a valuation in a more in-depth and calculated manner. The new investor becomes familiar with the venture at a more mature and established stage, which enables it to assess the startup’s value more accurately.
Furthermore, since a SAFE is a relatively standard agreement, there is no need for lengthy negotiations on comprehensive investment agreements. A SAFE defines clear rules about the investor’s rights (which include, inter alia, rights similar to those the next investors in the company receive during future rounds of funding).
Mechanism for Determining the Consideration
To understand how the investor’s consideration is determined, you first need to become familiar with two basic mechanism in SAFEs: the cap (maximum value) and the discount rate. Both of these mechanisms are used to determine a company valuation in order to later set the number of shares the investor will receive in consideration of its investment.
Cap –
This is the maximum company valuation predetermined in the SAFE. The cap constitutes a benefit to the investor, in that if the company valuation exceeds the cap in a subsequent round of funding, the investor will be entitled to its proportionate share of the company and to an allotment of shares as if the company valuation were lower, i.e., at the cap value.
Let’s assume, for example, that Investor A agreed in the SAFE to invest USD 0.5 million at a cap of USD 5 million. Let’s also assume that about one year after the SAFE investment, the company engaged in an investment agreement with Investor B for an investment of USD 1 million, based on a company valuation of USD 6 million. Because of the SAFE, although the company’s value was USD 6 million for Investor B’s investment, since the cap in the SAFE is USD 5 million, Investor A will be entitled to percentages of the company as if the company’s value were USD 5 million.
Discount rate –
The investor receives additional protection besides the cap, which is the discount rate on the company value to be determined in the next investment. According to this mechanism, the SAFE investor receives a particular discount (usually 20%) off the valuation determined in the next investment. The logic behind the discount rate is that it reflects the fact that the SAFE investor took a chance and believed in the venture before any future investor determined the company’s value. Therefore, such early investor is entitled to better investment terms.
If we use the previous example and add that the SAFE entitled Investor A to receive a 20% discount on Investor B’s valuation, then, instead of the USD 6 million valuation, Investor A will benefit from a valuation of USD 4.8 million that is even lower than the cap.
These two mechanisms are subject to negotiation (depending upon the parties’ bargaining power and other issues under negotiation). In customary SAFEs in Israel, investors may usually choose whichever of the two is more beneficial, either the benefit inherent in the cap or the discount rate on the determined company value. In other countries (mainly the United States), some SAFEs only include one of the mechanisms, depending upon the entrepreneurs’ bargaining power.
It is important to keep in mind that a SAFE contains numerous other conditions, which require the expertise of an attorney specializing in mergers and acquisitions, investments, and startups. Inter alia, a SAFE contains definitions of “qualifying events” when a SAFE investor becomes entitled to shares, the formula for calculating the investor’s holding ratio and the share price, the investor’s rights subsequent to its investment, and more. Such details, albeit seemingly “standard,” could turn an excellent investment transaction “on paper” into a terrible investment for the investor or the company. Therefore, it is important to draft such details meticulously and after receiving in-depth counsel.
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Barnea Jaffa Lande Law Offices are at your disposal for legal advice on High Tech, Startups, Corporate Law and related topic.
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