Our regular involvement in funding transactions for startups in the South African tech space often requires us to implement US-style investment terms and instruments to ensure that we are as relevant as the market needs us to be. In recent months the SAFE document (being an acronym for ‘Simple Agreement for Future Equity’) was introduced in the US venture capital scene and made its way to South Africa fairly quickly, where it has now become a popular method for early stage financing.
The essential terms of this document are that the investor purchases the right to subscribe for preferred shares in the investee company upon the next round of equity funding in the investee company. The most common method of calculating the number of shares to be subscribed for by a SAFE-holder is by applying an agreed valuation cap to the investee company upon issuing the SAFE document to the investor. By way of example, if US$1 million is invested at a valuation cap of US$3 million and the valuation of the company grows to US$5 million by the time the next round of equity funding is done, the SAFE-holder’s US$1 million investment will buy more shares than that of an equity subscriber also investing US$1 million at a later stage.
An alternative to the valuation cap, is to apply a discount rate to the investee company’s valuation upon the next round of equity funding and issuing preferred shares to the SAFE-holder based on the reduced valuation. This discount rate is specified in the SAFE document issued to the investor and has a similar effect to the valuation cap, but is calculated differently. If a 20% discount rate is applied in the scenario above, that means that the investee company’s actual valuation on the next equity round (US$5 million) is reduced by 20% to calculate the preferred shares to be issued to the SAFE-holder. In this case that would mean that the SAFE-holder subscribes at a valuation of US$4 million.
The SAFE document can also include both a valuation cap and a discount rate, in which case the document will state that the method of calculation which results in the greater number of shares issued to the SAFE-holder will be applied. By way of example, based on the scenario above, if a valuation cap of US$3 million and a discount rate of 20% is provided for in the SAFE document, the valuation cap (and not the discount rate) would be applied, as that will result in more shares for the investor.
If the company’s valuation drops to below the valuation cap by the time the next equity round is implemented, the valuation cap is merely disregarded and the SAFE-holder subscribes for preferred shares at the same valuation as the other subscribers.
One of the reasons why SAFE documents were developed is to limit transaction fees by using a simple standardized document, cutting out significant costs, time and effort usually spent on closing equity funding rounds. This also enables the investee company to close transactions with investors (and get the funds needed in the business) one investor at a time, as each investor negotiates separate terms with the investee company. This can prevent the situation of one stubborn investor holding up a whole funding round.
Other positives are that the investee company can offer different valuation caps to different investors, depending on the timing of the investment or even the reputational or experiential value of the investor. Having flexibility in the valuation offered to different investors may be very useful when negotiating with investors who can contribute more to the business than just their monetary investment.
This may all sound very attractive to investors, especially if you consider that the flexible valuation may be a very effective way to reward the risk of very early stage investment with a higher return. However, the picture becomes slightly less exciting if you consider the SAFE-holder’s position in more detail.
Here are some of the obvious areas of concern from an investor’s perspective:
- The SAFE-holder only subscribes for preferred shares in the investee company upon the occurrence of specified trigger events. These are usually an initial public offering (‘IPO’), the next round of equity funding, any other change of control or the dissolution of the investee company. In the interim period (unlike holders of convertible debt), the SAFE-holder is not a creditor, as the SAFE -document is not a debt instrument (there is no obligation on the investee company to repay the investor, no interest and no security). This means that the investor will have no recourse or further rights unless a trigger event occurs, which can be very problematic if, for instance, the investee company keeps on raising capital by issuing more SAFE documents to third party investors.
- Unlike convertible loan notes, the SAFE document does not create an option in the hands of the SAFE-holder, as the subscription will happen automatically upon the occurrence of a trigger event. The only exception to this is where an IPO (the SAFE-holder has the option to subscribe for ordinary shares) or other liquidation event (the SAFE-holder has the option to have its investment returned) occurs. This means that a convertible loan note holder will be in a better position than a SAFE-holder, as the convertible loan note creates a debt with a defined payment obligation and an option for the holder to remain a creditor or subscribe for shares in the investee company.
- Once the SAFE-holder subscribes for preferred shares in the investee company, its preferred shares will have a liquidation preference (like other preferred shareholders). However, if the SAFE-holder subscribed for shares at a lower valuation than that of the other preferred shareholders, the SAFE-holder’s liquidation preference is calculated on the lower valuation (i.e. on a lower ‘per share’ liquidation preference than that of other preferred shareholders).
- When signing the SAFE document, the SAFE-holder does not know what the terms of its shareholding with the investee company will be. It knows that they will be materially similar to those of the other preferred shareholders, but that may not always be favourable for the SAFE-holder. If, for instance, other preferred shareholders are related to the founders of the investee company in some way, the rights attached to the preferred shares may be structured with slightly ‘lighter’ protective mechanisms (like vesting of founders’ shares, restraints, preferred distribution rights) compared to terms usually included in early stage funding transactions.
When we advise investors on SAFE documents, we aim to mitigate some of the risks highlighted above, by including certain restrictive measures not included in the standard SAFE document. These may include a restriction on the investee company to only source a limited amount of funding through the issuing of SAFE documents. This will ensure that the investee company does not delay the equity subscription with endless issuing of SAFE documents. In addition to this, we would also suggest to investors that there should be a time limit to the SAFE document, which triggers repayment (in real terms) or equity subscription (at the SAFE-holder’s option) if an equity funding round (or other trigger event) does not occur by a certain date.
Considering the above, it is clear that the SAFE document may hold certain advantages for both the investor and the investee company. However, it remains to be seen whether investors are willing to accept the risks associated with the SAFE document in its standardized form.