A SAFE is designed to be short and straightforward. In essence, the investor provides cash now against a promise to receive shares in the future. The challenges of negotiating full transaction documents, including agreement on the company’s valuation, are postponed to a later date. The entrepreneur is supposed to be happy as he (or she) receives investment for the company’s immediate use. At the same time, the investor is supposed to be happy, as he (or she) is protected against market volatility by negotiating a conversion cap and discount rate. Which in the current market, is particularly attractive to both investors and entrepreneurs. But, as the saying goes, the devil is in the details.
The Volume of the Future Fundraising Round
The principle of a SAFE is that when the company next raises money, the SAFE will be converted into shares of the company. But the question is how many shares? The conversion may be carried out according to a valuation cap or a discount rate pre-determined in the SAFE, or the more preferable of the two options. As an investor, you would always want to include both options in your SAFE.
For example, an investor invests $100,000 in a SAFE, with an agreed 10% discount rate and company valuation cap of $10 Million.
Calculation According to the Discount Rate
The total shares are calculated according to the SAFE money invested divided by the share price in the next round, multiplied by the discount rate.
If we take our example above, if during the next financing round, the company raises money according to a share price of $10. The investor would be entitled to receive the number of shares equal to $100,000 (the SAFE amount) divided by USD 9 (i.e. a 10% discount off the share price during the fundraising round) = 11,111 shares.
Calculation According to the CAP
The Safe amount divided by the cap, divided by the company capitalization. Generally speaking, a company capitalization is the capitalization of the total shares and options of the company. However, as explained below, the definition of this term is negotiable.
Again, if we take our example above, and the cap is $10 million, and the company capitalization is 1 million shares, the investor will receive the number of shares equal to $ 100,000, divided by $10,000,000, divided by 1,000,000 = i.e. 10,000 shares.
Since the conversion of the discount provides a higher number of shares, the investor will use that mechanism and receive 11,111 shares.
However, these conversion mechanisms have several nuances:
A. It is important to precisely define what will be considered a fundraising round. In other words, will an investment of “only” $100,000 trigger the conversion of the SAFE? It is usually customary to set a specific threshold that reflects the company’s fundraising needs and goals in the upcoming year. From the investor’s perspective, there are several reasons for setting a high minimum threshold to trigger conversion of the SAFE:
– According to the SAFE, during the next round, the investor will receive shares and their attached rights “as if it were part of the round”. Therefore, the investor will want to convert the SAFE when a significant investment is injected into the Company, which will most likely generate preferential rights and terms for the investor.
– Setting a high minimum threshold may also be beneficial for the investor because it will postpone the SAFE’s conversion and protect it from dilution in the interim period. (On the other hand, until the Safe has converted the Investor will typically not have any shareholder rights in the Company).
Sometimes, an investor will also negotiate an additional parameter, “non-qualified equity financing,” which reflects a fundraising round that is lower than the defined minimum threshold but, unlike with a qualified financing where conversion is automatic, in this instance, the investor will be able to decide, at its sole discretion, whether to convert the SAFE or, alternatively, to continue holding it until an investment is made at better terms.
Challenges when negotiating this clause derive from the fact that the company generally has an interest in keeping the cap table “clean” without being forced to calculate a multitude of future conversions at different rates that may lead to uncertainty, and simultaneously negotiating a higher valuation with a third party while converting SAFEs at significantly lower caps. Therefore, the company will prefer not to define any minimum investment threshold or, at the very least, will try to keep the threshold low.
B. Using the valuation cap also raises an additional complexity. With this formula, the definition of the “company capitalization” has a real impact on the number of shares that the investor will receive as a result of converting the SAFE. In the cap formula, the company capitalization is the denominator of the equation and therefore, the larger it is, the lower the price per share will be and as a result the investor will receive a larger number of shares. That being the case, the investor should strive to include as many parameters as possible in this definition (for example, promised options and unallocated options etc.), while the company will want to narrow the definition as much as possible.
The SAFE’s Maturity Date and its Optional Conversion
What happens if the investor holds the SAFE for a long time and the company does not raise funds? As an investor you may want to convert your SAFE amount, to become a shareholder in the company. This is why an investor should ask for a maturity date (typically 12-24 months) and the right to convert the SAFE at will thereafter. The underlying principle of the SAFE is that it is a bridge loan, until the “real financing”. If the founders failed to raise the “real financing” there is an argument that it should bear the consequences, i.e. a reduced valuation cap (which would give the investor more shares upon conversion) following the maturity date.
In any case of conversion, the investor should ensure that it is converting into the most senior class of shares existing in the company at such time.
Liquidation Priority when Distributing the Company’s Assets
What happens if the company is liquidated, or on a more positive note, achieves an exit by way of a merger, sale or IPO (each a liquidity event)? It is customary for the investor to be entitled to receive the higher of the following: (a) the money it invested under the SAFE; or (b) an amount equal to its portion of the exit amount, assuming that the Safe amount converted into the most senior class of shares of the company immediately prior to the exit, at the valuation cap or the discount rate on the exit valuation, whichever is more preferable to the investor.
The question is: Who will be entitled to receive money first? Will the SAFE-holder receive its money before the holders of the preferred shares? Will one SAFE-holder have any priority over the other SAFE-holders? These are all key questions that affect investment risks, and it is important to address them when drawing up the SAFE.
If we are using the cap, then again the cap must be divided by the company’s capitalization, which is defined differently in this scenario (Liquidity Capitalization). Again, the investor should try to include as many parameters as possible in the definition, while the company will try to narrow the definition. The differences between the final negotiated definitions may have a significant impact on the return that the investor will receive during the exit.
In addition to the terms elaborated on above, there are other points to consider. Is this a new investor or is the SAFE-holder already a shareholder in the company? If the investor is already a shareholder in the company it will need to weigh protecting his/her new SAFE money against dilution of his/her “old” money that was previously invested in the company.
An investor should also always push for an MFN clause, so that if in the future the company allots securities to a third party on preferential terms, it will receive the same, and pay attention as to how the SAFE can be amended/changed.
Bottom line, a Simple Agreement for Future Equity is not so simple, and the terms can be improved.
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Adv. Dean Weinberg is an associate in Barnea Jaffa Lande’s Corporate department.