By Cliff Ennico
“I have a small but growing technology business. I have been reading online lately about a new financing device for startup companies called a ‘SAFE.’
Do you know anything about it, and is it something I should consider when raising capital for my business?”
Traditionally, there are only two ways an investor can make an investment in a startup company. Either the investor makes a loan to the company, which is repaid with interest (called “debt”), or buys shares in the company entitling the investor to a percentage of the company’s profits and losses (called “equity”). When a company goes out of business or liquidates, holders of debt get their money back before holders of equity get anything.
Equity can be either “common” or “preferred”. Holders of preferred equity have the right, upon liquidation of the company, to get their money out before the holders of common equity get anything. Holders of common equity are at the bottom of the pile: if the company liquidates, they get whatever is left over after the holders of debt and preferred equity get paid back in full.
Debt can be convertible into either preferred equity or common equity, either at the option of the investor or (in certain circumstances) at the option of the company.
There are two problems with debt, convertible or otherwise:
- It must be repaid, with interest, at specific times; and
- It must be carried as debt on the company’s books and records, which sometimes deters equity investors who come on board at a later time.
To avoid these issues, startup companies sometimes issue “strip rights” to their early stage investors. These rights are neither debt nor equity, but give the holder the right to receive a percentage of the proceeds of specific transactions – such as an initial public offering (IPO), a merger or acquisition, or a venture capital investment of $1 million or more — if and when they occur. If the transaction never occurs, the “strip right” holder gets nothing. If the transaction does occur, the “strip right” holder gets her percentage of the transaction proceeds before anyone else gets anything.
“Strip rights” are usually payable only in cash, and are given in exchange for services to the company without a specific value. But what if a startup company were to give an investor, in exchange for a cash investment (not services) a “strip right” payable, not in cash, but in shares of stock when one of the specified transactions occurs?
That sort of “strip right” is called a “Simple Agreement for Future Equity” or “SAFE.”
When issuing “SAFEs,” the company and investor agree on a “Valuation Cap” – essentially a target valuation of the company — and the investor receives the right to receive a number of shares of preferred stock based on the Valuation Cap. If the company later issues preferred stock for a price per share higher than the Valuation Cap, the investor receives the agreed-upon number of shares of preferred stock. If the company subsequently liquidates, the amount a SAFE investor would receive before other investors would be equal to the original investment amount.
If the company later issues preferred stock for a price per share lower than the Valuation Cap, the investor receives the same preferred stock, at the same price, as the other investors in the later financing, and would share equally with those investors if the company later liquidates.
If the company later goes public, merges with another company or is acquired by another company, the investor can either convert the SAFE into shares of common equity (not preferred equity) based on the Valuation Cap, or receive a return of her initial investment without interest, at her option.
If the company liquidates before the SAFE is converted into preferred equity, the investor would receive her money back before other holders of common equity get anything (but after any debts are paid off).
Unlike debt, a SAFE has no expiration or maturity date; it terminates only when an investor has received stock or cash in a subsequent offering of equity, a merger or acquisition, a public offering or liquidation, whichever occurs first.
Like a “strip right,” a SAFE appears on the company’s capitalization table (list of owners) in the same way as an option, warrant or convertible security would, but does not appear as either debt or equity on the company’s financial statements.
While SAFEs do not appear to be illegal, I have three concerns about them:
- Setting the Valuation Cap for a startup company that has neither revenue nor profits is going to be highly speculative;
- The tax consequences to the investor of converting SAFEs into preferred stock are not clear; and
- Asking an investor to hold onto a SAFE indefinitely without interest or any sort of cash return prior to conversion is going to be a tough sell.
If it were me, I would call these investments “SAFEMS” – for “Speculative Agreement for Future Equity, Maybe, Someday.”
Cliff Ennico (cennico@legalcareer.com) is a syndicated columnist, author and host of the PBS television series ‘Money Hunt’. This column is no substitute for legal, tax or financial advice, which can be furnished only by a qualified professional licensed in your state. To find out more about Cliff Ennico and other Creators Syndicate writers and cartoonists, visit our Web page at www.creators.com. Copyright 2013 Clifford R. Ennico. Distributed By Creators Syndicate, Inc. Follow Cliff: @cliffennico.
