FINANCING 101 FOR STARTUPS: PART 1
Startups need capital to grow and scale their business. In this three-part series, we will walk you through the most prevalent methods of raising capital at an early stage for emerging growth companies. This series will provide founders with a high level understanding of three common investment structures: SAFE financings, convertible debt financings and equity financings.
In this post, we will discuss SAFE financings based on the standard Y Combinator form of SAFE that is used in the market.
A “SAFE”, or a simple agreement for future equity, is a pre-seed (or bridge) financial instrument that provides an investor with the right to convert their investment into equity of the company at the time of a future equity financing, liquidity event or a dissolution event. While many SAFEs are utilized by pre-seed companies, SAFEs have also become a common tool for providing bridge financings, and are particularly appropriate when companies and investors are confident an equity financing will materialize. SAFEs are a beneficial option for founders because they are standardized in the market and involve minimal negotiation, which reduces documentation, an assessment on company valuation and overall costs involved with a negotiated priced round. However, they are considered a higher risk form of investment from an investor perspective, since there is typically no maturity, interest or repayment provision included in a SAFE.
A standard SAFE includes a “Discount Rate”, a “Valuation Cap”, or both. There are two types of Valuation Cap SAFEs: (i) a pre-money SAFE, and (ii) a post-money SAFE. Keep in mind, the Valuation Cap of your SAFE is not necessarily your company’s current valuation (you are effectively punting that down the road to a future priced round / equity financing). The post-money SAFE is the current market standard for SAFE financings as it provides more certainty to both the company and investor as to the dilutive effect of the SAFE at the time of conversion. “Post money” refers to the ownership of a SAFE holder at the time of conversion before new money is invested into the corporation. For example, if a company is raising a seed preferred share financing and has an investor with a $1M SAFE that converts at a Post-Money Valuation Cap of $10M, the SAFE holder would typically own 10% of the company immediately prior to the issuance of new equity in the seed preferred share financing.
In the context of an equity financing, a SAFE investor will receive the same class (albeit often a different series of that same class to account for the different conversion price of the SAFE vis-à-vis the new money) of shares issuable to new money investors at (A) an agreed discount to the price per share paid by the new investors (if the SAFE includes a Discount Rate), (B) at a price equal to the lesser of (i) the price paid by new money investors, or (ii) a price per share calculated by a “Valuation Cap” divided by the “Company Capitalization” immediately prior to the new money investment (if the SAFE includes a Valuation Cap), or (C) a price equal to the discounted price per share or the price per share based on the “Valuation Cap” divided by the “Company Capitalization”, whichever price results in more shares to the SAFE holder (if the SAFE includes both a Discount Rate and a Valuation Cap).
In the context of a liquidity event, an investor will receive an amount equal to the greater of (i) their initial investment, and (ii) the amount they would have received if their SAFE had converted into common shares immediately prior to the liquidity event (based on the Discount Rate, Valuation Cap, or both, as set forth in the SAFE).
If a dissolution event occurs before the SAFE otherwise converts into an equity financing or liquidity event, the investor is entitled to receive their initial investment back immediately prior to the consummation of the dissolution. In the context of either a liquidity event or a dissolution event, a SAFE holder’s right to proceeds is subordinate to outstanding senior debt, on par with payments to other SAFE holders or preferred shareholders and senior to payments to holders of common shares (typically founders).
SAFEs can be an important financing tool – particularly for early stage emerging growth companies, but there are subtle differences and important nuances with respect to SAFE terms that you should be aware of (and be warned that there is such a thing as a maximum amount you can raise on a post-money SAFE!). If you intend to embark on a SAFE financing or would like to learn more about SAFEs, please reach out to Chase Irwin (firstname.lastname@example.org) or Sean Del Giallo (email@example.com) at Dentons Canada LLP and we’d be happy to discuss.