One of the age-old problems for startup entrepreneurs in recruiting angel investors is putting a value on their company. Startups happen because the entrepreneurs think they have a great idea for tapping a lucrative market. If they executive on their plan, they think their company will be valuable.
Angel investors have heard it all before. Great ideas new great execution, a stellar team, fortunate market timing and a little luck to hit it big. Roughly 90 percent of all startups will fail, so the value an angel investor will put on a pre-revenue startup is usually heavily discounted.
The SAFE agreement (an acronym for “Simple Agreement for Future Equity”) is one recent development that tries to bridge the gap between the entrepreneur’s optimistic vision of future value and the angel investor’s pessimistic appraisal of risk.
First introduced by Silicon Valley incubation firm Y-Combinator (an organization that claims to have funded more than 800 startups since 2005 with a combined valuation of more than $30 billion) the SAFE agreement gives the investor a non-quantifiable equity interest in the issuer that will convert into preferred stock at a defined conversion rate when the next qualified investment round occurs.
The conversion rate usually is based on the valuation given the issuer in the qualified investment round, often with a discount in favor of the investor. In one alternative, the conversion rate also can be capped, giving a further benefit to the SAFE investor who effectively buys in at a lower valuation than the investors in the qualified round.
In many ways the SAFE Agreement functions much like a convertible note. The investor puts money to work and eventually converts into equity at a valuation determined by a subsequent group of investors who have the benefit of hindsight.
Unlike a convertible note, however, the money invested in the SAFE does not accrue interest, thereby benefiting the issuer. Also, without having a debt overhang the startup is better able to borrow money later if needed.
While the SAFE investor will not have the liquidation priority of a convertible note holder, the SAFE agreement contemplates a liquidation preference for SAFE investors that comes ahead of other equity holders.
SAFE investors also are protected in a change-of-control transaction (such as an acquisition of the startup or a merger) because SAFE investors will have the option to either get their money back or convert into common stock of the issuer immediately prior to the consummation of the change-of-control transaction.
The SAFE is also different from a convertible note because the SAFE has no maturity date and never expires. If the startup thrives and reaches its financial goals without the need of additional investment, so much the better. The SAFE investor continues to hold its SAFE security with the conversion rights entailed.
The SAFE investment model seems to have received more acceptance on the west coast. Many angel investors on the east coast are just becoming acquainted with the model, so some early stage companies may experience some delays as they explain the model to some early stage investors.
It is also not clear how well accepted the SAFE model will be for crowdfunding (and quasi-crowdfunding) platforms such as Angel List, SeedInvest and others. Some of the investors on those platforms are less sophisticated than others and it’s possible that a SAFE offering on a Web platform, which certainly is permitted under SEC Rule 506(c), may require some extra explanation and socializing.