MCC: In a well-received client alert, you discuss a burgeoning interest in Simple Agreements for Future Equity, or SAFEs, in the start-up investment space. Would you kick off this discussion by telling us what a SAFE is?
Sorin: Sure. A SAFE is a new instrument or a new mechanism to raise capital, particularly by early-stage companies. Technically speaking, a SAFE is really nothing more than a contract, pursuant to which somebody interested in investing in a company actually puts the capital into the company in exchange for a promise on the part of the company to issue equity to that person in the future, where the terms and conditions of the equity instrument to be issued in the future will be virtually identical to those terms and provisions that apply to a subsequent priced equity round, with the only potential variations being price (affording the SAFE investor a discount off of the price paid in the subsequent equity round) and/or a capped conversion price, or maximum valuation at which the SAFE converts to equity.
SAFEs are expected to be used primarily for early-stage companies for which a current valuation, one of the starting points and key elements of a priced equity round, is difficult to ascertain because there often are no observable or measurable metrics of performance at that point.
MCC: How does a SAFE differ from convertible debt or a priced equity round?
Sorin: That’s a good question. A SAFE is the least complicated and arguably the least sophisticated mechanism. A priced equity round obviously involves the immediate issuance of equity to the investor in exchange for the dollars invested. There is substantial negotiation regarding valuation as well as the rights, preferences and designations of the equity instrument being issued.
Long ago in the world of technology and corporate finance (but really not that long ago in real time), there was a recognition – particularly insofar as it relates to companies seeking early-stage capital infusions – that while there may be a preference for doing a priced equity round, there's often a disconnect between the investors and the company’s management regarding valuation. The reality is that for very early-stage companies, the investment decision is based primarily upon the problem being solved, the business plan, the strategy, the market opportunity and the management team. But in so many cases, the company has not yet performed. In the absence of any performance, it’s debatable as to whether you can determine a meaningful valuation for the purpose of pricing the equity that's being issued. This disconnect led to an increase in convertible note financings, which at their core were an attempt to kick the can down the road on valuation and recognize, basically, that both parties agreed that it's too difficult to determine valuation today. This would give the company the runway to do its development – maybe create a working prototype, maybe get some beta testing – and get to the point at which there's a consensus as to valuation, a larger financing and an independent third-party investor assessment.
An investor who puts in that earlier money typically expects a better return than later investors will enjoy under the terms of a priced equity round perhaps some 12-18 months later. Obviously the risk profile is far higher at that earlier stage of financing. And so convertible note deals started to become more sophisticated. For example, with the newer notes, the price per share effectively paid by the convertible note holder upon conversion would be discounted versus the terms offered to the new investors in the priced equity round, typically by 15-25 percent. The discount is meant to effectively compensate the investor for the earlier risk undertaken.
Then these transactions became even more sophisticated because investors began to realize that their money was empowering the company to develop, and the concern became that the company might develop rapidly, with valuation increasing dramatically. So they started to insert the concept of a capped conversion price, which basically set forth the maximum price the note holder would have to pay when the calculation was done to convert the outstanding debt, plus accumulated but unpaid interest, into equity. One can readily see that if the company's subsequent equity round involves a $10 million valuation but the capped conversion price is $4 million, the convertible note holder obviously prefers the inclusion of a cap on valuation at conversion.
MCC: So there's a certain mitigation of risk in all of that.
Sorin: Exactly right. Enter SAFEs. The SAFEs are an attempt to recognize that a convertible note transaction really is a bit oxymoronic because there is, in all likelihood, no expectation of repayment of the notes – either the company succeeds and there is debt-to-equity conversion or the company fails and the noteholders’ investment is lost. Although convertible note deals remain simpler to do than priced equity rounds, with shorter timeframes and less documentation, they nevertheless have become more complex over time. While these deals have certain cost and time-to-consummation of financing benefits over priced equity rounds, some companies and investors believe that SAFEs are an even more attractable alternative. They are far less costly, and there's very little in the way of negotiation. If you have a willing company and a willing investor, SAFEs can be done extremely quickly.
In a time when there's an incredible amount of entrepreneurial activity and a demand for early-stage financing and for early-stage companies in which to invest, Y Combinator (a leader both in the early-stage investments space and in helping to mentor and accelerate early-stage companies) has come up with this concept of SAFE, again literally “simple agreement for future equity,” meaning a contract where investors put their money in now and simply agree to take whatever terms the subsequent equity investor negotiates and receives.
The downside is in not having the same safeguards that are built into convertible note deals, but the flip side of that is that you have a far simpler arrangement. And of course, no one transaction type or financial instrument will be a good fit for all companies and investors at all times. I would think that most venture capitalists, corporate partners and strategic partners will shy away from SAFEs because of the relative lack of safeguards and protective provisions as compared with priced equity rounds and even convertible note deals. In most instances, however, the most important and extensive safeguards are not built into convertible note deals either, so I believe SAFEs also have their place, and they need to be considered very carefully among the various types of instruments available. They are more likely to be embraced by angels, high-net-worth individuals and technology company executives who seek to invest in other technology companies.
In fact, our firm is handling one of the first SAFE transactions that I'm aware of on the East Coast, for an early-stage, high technology company. All of the investors are individuals who are senior executives at well-known technology companies. So I can see how someone with that kind of entrepreneurial inclination might be more willing to take the added risk of the SAFE than the later-stage investor, or an investor who wants the greater certainty and the protections associated with the priced equity round.
There are four flavors of SAFE. The simplest, literally, is nothing more than the contract we talked about: “give my start-up dollars X today, and when we do a priced equity round in the future, your money will be converted into that equity instrument on the exact same terms and conditions.” I think this flavor will get the least amount of interest because it doesn’t recognize that the earlier money took the greater risk and should somehow be compensated for that.
Then there are two flavors in the middle. The second says, "Well, we're going to take a discount but no other provisions beyond the normal contract we talked about.” So it's a way of saying, "We'll put the money in now; we'll take whatever equity instrument is issued by the company in the future – on the same terms, except our price will be discounted." The discounted price likely would mirror what we'll see in convertible note transactions: 15 to 25 percent. The third flavor, if you will, is “no discount,” but there will be a capped conversion price much like we talked about with respect to convertible note financings, so investors get the protection of knowing that no matter how high valuation of this company goes, they are not going to pay an effective price higher than some negotiated valuation at some point in the future. Finally, the fourth flavor of SAFEs, and the one most likely to be accepted, will have both the capped conversion price and the discount. But those are really the only two points of negotiation and protection or added incentive for the investors.
Some people believe that there's a gross misalignment of interest. Some will be concerned about a level of dilution that is uncertain and incalculable at that time of the issuance of the SAFE. Others are concerned about the absence of protective provisions, veto rights, board seats, rights of first refusal and co-sale and drags and tags, et cetera, that are common in priced equity rounds. But notwithstanding that and the debate that is likely to be unleashed this year, my personal view is that, like priced equity rounds and like convertible note transactions, SAFEs will be embraced by some, if not many, companies because the risk-reward profile will be analyzed with some concluding that notwithstanding the risks, SAFEs make sense for some companies at certain stages of development.
And I do believe that some investors – particularly where they're very excited about the prospects of the company because of its market potential or industry segment – will be willing to make the bet that, notwithstanding some of the downsides of SAFEs, it’s a simple, easily adoptable mechanism for raising money very quickly at the early stage. And if there's a cap and a discount, then at least there is some (albeit imperfect) protection for the investor.
MCC: Talk about the West Coast/East Coast dynamics as far as SAFEs are concerned.
Sorin: No problem. It doesn’t surprise me at all that the West Coast is more of an early adopter, not only of new technologies and new types of solutions but also new ways of investing in related companies. Also, the fact that Y Combinator has been an advocate of SAFEs helps early-stage companies or individual investors feel more comfortable embracing them. And frankly, the dynamic also springs from the fact that the market is very hot, if not overheated, meaning that investors are thinking "I've got to get in and therefore, I'm willing to invest even in the absence of certain safeguards that I might otherwise require."
With respect to the East Coast, I'm going to take a little bit of a "wait and see" attitude. One of my fellow partners at McCarter has handled an East Coast SAFE transaction on behalf of a New York-based investor in a Canadian company, and I’m currently handling a SAFE deal for a New York-based technology company. But all of the investors in my deal are West Coast-based, so I do think the jury is out on how fast and how deep East Coast penetration is likely to be. East Coast investors tend to be more conservative, even in venture capital deals. You can almost always detect an East Coast- versus a West Coast-initiated transaction. Investors remain less risk averse in the West.
Like convertible note deals, SAFEs should be considered and should not automatically be eliminated because of controversy. There will be a fair amount of controversy and debate. Our firm, along with professionals in the accounting, finance, legal and insurance sectors, will be hosting such a debate on SAFEs in February. We are bringing together a group of investors – VCs, angels, high-net-worth individuals – and companies to hear directly from them their perspectives on SAFEs.
MCC: What will we be hearing from investment companies and venture capital firms?
Sorin: I suspect that we will hear that some will happily embrace SAFE transactions, notwithstanding the uncertain dilution. Certain of them will like SAFEs for their simplicity and/or the investor’s willingness to rely on later-stage investors to negotiate the right kind of deal in the priced equity round. I suspect that most venture capital firms will not embrace SAFEs and likely will not invest in them; however, one of today’s big unanswered questions is whether VCs will be reluctant to invest in companies that completed earlier financing rounds through SAFE transactions.
Remember, there was a lot of debate on convertible note transactions when they were introduced and much of that debate continues to this day. Many venture capitalists don't like convertible note transactions. But even if they won’t participate in a convertible note transaction, many, if not most, will invest in companies that have completed convertible note transactions in their past. So my preliminary view is that, while VCs are not likely to be SAFE investors themselves, I don't believe that they will refrain from investing in companies that have undertaken SAFE transactions prior to the priced equity round – because they will miss some really excellent opportunities, which of course they don’t want. And protections can be garnered based on the manner in which the priced equity round is undertaken. So the jury is out. The old expression that “time will tell” is very true here. But no one should assume that SAFEs will not gain at least some traction and potentially become a significant tool that can and should be considered, along with all other methods of gaining access to capital available to early-stage companies.
MCC: What should MCC’s readers take away from this discussion?
Sorin: The main point is that SAFEs are aptly named. They involve simple four-page documents that comport with the four flavors I mentioned above, meaning that they require very little in the way of negotiation. Certainly, SAFEs are not, nor are they intended to be, the answer for all companies or investors. Once thoroughly vetted, understood and utilized, I suspect them to play a reasonably significant role in funding start-ups, but likely in pre-institutional or pre-venture capital rounds. In an era, such as today, when entrepreneurial activity and new company formation drive innovation, job creation, and wealth accumulation, it is important to at least consider new alternatives that have the potential to increase access to capital and respond to disparate needs of companies and investors.
Published January 27, 2015.