When it comes to raising capital for early-stage companies, one of the most difficult and potentially problematic undertakings that a business owner encounters is establishing a valuation for the new company. In the earliest stages, there’s usually no financial or operational history to go off of, and the team is raising capital to start the building process.
In the past, a convertible note was often the best market solution out there for these situations. However, convertible notes typically accrue interest and, more problematically, a maturity date. Putting an “end date” on early financings did not make sense for a lot of new startups.
In response to this problem for startups raising capital, the first SAFE (Simple Agreement for Future Equity) was developed by Y Combinator in 2013. The basic premise was simple – SAFEs are agreements that entitle the holders to discounted equity in a business in a subsequent priced equity round, IPO or other liquidity event. This allows a startup to avoid setting a price for a round while still giving investors the benefit of converting to equity at a discount in the future.
How does a SAFE typically work?
SAFEs typically have some combination of a valuation cap and a discount.
The valuation cap is set at a certain dollar value (ex. $3 million). Note that this is not the valuation of the business. Instead, it’s a cap on the future valuation that gives investors some potential upside. When a future valuation event occurs (i.e. a funding round or a sale of the business), the SAFE can convert to equity. If the business’ valuation at the future event is higher than the valuation cap, then the investment converts to equity as if the investor invested at the lower valuation.
SAFEs may also include a discount (ex. 20%). The discount gets applied when the business’ valuation at a future event is set below the valuation cap (or in cases where the SAFE did not include a valuation cap). In this instance, the discount will be applied to the future event valuation to determine the valuation at which the SAFE will convert to equity.
Who is a SAFE best for?
SAFEs can be a good option for businesses that have a lot of upside potential but are unable to set a valuation for the company at an early stage.
SAFEs are often compared to convertible notes. Without the accruing interest and maturity date of a convertible note, it can be less of a burden on the business. This is especially attractive for businesses that may not expect to have the ability to pay off a convertible note within a typical maturity window.
While the basic framework of a SAFE is well-suited to many startups seeking venture capital or angel investors, the unique environment of investment crowdfunding presents challenges that require a modified security instrument in order to best serve the interest of investors participating in an offering under Regulation Crowdfunding or Rule 506(c) of Regulation D.
As a result, we decided it was necessary to create our own standardized instrument, which we’re calling the NextSeed SAFE.
About the NextSeed SAFE
The NextSeed SAFE is a version of the SAFE that has been customized for crowdfunding. It aims to supplement the flexibility of the SAFE with specific rules that make cap table management easier for issuers and protect investors with respect to conversion price and distribution payments.
What are the unique attributes of a NextSeed SAFE?
- Clean Cap Table
One of the key concerns that businesses have when crowdfunding with a SAFE agreement is that investors in later rounds (especially Venture Capital firms) don’t want to deal with a cap table with hundreds of investors.
The NextSeed SAFE is structured so that conversion to equity only occurs upon (i) a future equity financing if the issuer decides to trigger the conversion, or (ii) a future liquidity event (such as an IPO or sale of the business).
- Investors Lock in Conversion Price
Upon the first new round of financing following issuance of the SAFE, investors in a NextSeed SAFE are locked into a conversion price (even if the issuer chooses not to convert the SAFEs to equity at that time).
Either the valuation cap or the discount is used to set the valuation at which investors will convert. No matter how many additional rounds of financing occur, the conversion price for investors in the NextSeed SAFE will remain unchanged.
- Voting Rights
Upon conversion, NextSeed SAFE holders will not have any voting rights or management rights in the business, except those required by law. For any required voting rights, each investor in a NextSeed SAFE is required to grant a proxy to NextSeed Services LLC to vote on their behalf.
- Dividend Payments
To ensure that NextSeed SAFE holders are not negatively affected by any postponement of conversion by the issuer, investors are entitled to their pro rata share of any dividends or other cash distributions paid out by the business to its equity investors (calculated at such time on an as-converted basis). Even if a business delays its conversion multiple times, investors will receive the payments they would have otherwise been entitled to as converted equity holders.
The exact terms of a NextSeed SAFE offering will vary with each campaign, so make sure to review the campaign documents thoroughly.
By creating the NextSeed SAFE, we aim to create a business-friendly security that also better protects the interest of investors participating in a crowdfunded offering. We’re proud to offer this product on the NextSeed platform and encourage you to have a look at our current NextSeed SAFE offerings for further exploration.
The NextSeed Team