Given the drop in valuations from monumental zero-interest rate heights in 2020, driven by the sudden hawkish turn of central banks worldwide, founders seeking capital have increasingly turned toward mechanisms to ‘wait out the storm’ and delay their next priced round before markets recover.
One of the most common methods is through a Simple Agreement for Future Equity, or SAFE for short. SAFE notes are similar to Convertible Notes in that they postpone the most critical terms (valuation, dilution etc) until the next priced round. This allows founders to push pricing to a date where the business is demonstrating greater traction, as well as securing an agreement quickly when cash is needed.
Where SAFE Notes differ to Convertible notes is the lack of a debt element, further reducing negotiation time and complexity. These agreements are an efficient and effective form of bridging investment while awaiting a high confidence (near-term) milestone, contract or partnership.
While at face value these agreements look to be a free shot at increasing valuation while saving time, a growing reliance on these sugary agreements can rear hidden future costs when used inappropriately.
It has become a common phenomenon for businesses to raise multiple of these notes in succession when their expectation of a returning market doesn’t materialize. This can lead to two issues when it’s time to undertake a priced round:
When attempting to raise a priced round, successive SAFE notes looming in the background can sometimes create a messy cap table and turn away interested investors. For these new investors, converting SAFE notes often consume too much equity, meaning the incoming investor will get less equity ownership for the same dollar amount invested.
Lets take for example, a business with the following cap table and no outstanding SAFE notes:
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The business wants to raise a $15m Series B at a Pre-Money Valuation of $30m
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Now, if this same business had instead raised two SAFE note rounds instead of the Seed and Series A:
Then the pre-raise capital structure would be the following:
Again, the business wants to raise $15m at a $30m Pre-Money Valuation
Therefore, the post-raise cap table (with converting Pre-Money SAFE notes) would be:
The SAFE strategy has worked brilliantly for the founder as valuation improvement has come to fruition. The founders equity holding is 44% in the SAFE scenario compared to 30% in the straight equity.
However, what is often missed is the impact on the incoming investor. For the same amount of dollar spend, this investor only owns 25% of the company compared to 33% in the straight equity scenario. This places an investors IRR at an immediate disadvantage, as well as potentially lowering ownership percentage to below fund mandates. This will lead to investors walking away from a deal in some cases.
This demonstrates the balancing act of dilution at the cost of deterring future investors. If this equity is required to sustain the current operations or pursue growth, then the business is at a slight disadvantage.
The above scenario worked from a dilution perspective as valuation predictions came to fruition. However, it is important to note that the valuations seen in the heights of COVID and zero interest rates were abnormal, not the default norm. So, what happens to SAFE notes if valuation doesn’t hockey stick?
Looking at another example:
SAFE 1: $2m at a $15m Cap
SAFE 2: $3m at a $15m Cap
Here, the business has not hit the milestones expected from the first SAFE and raised a second one hoping to bridge the business to a higher valuation equity round. In compensation for a larger cap, a 30% discount term was negotiated.
However, the market in the meantime slid further (or milestones were delayed) and instead the business is now valued at $12m pre-money and needs to raise $10m in a straight equity round.
Here, the founder has been diluted from 90% to 37%, despite only taking on $15m worth of equity. Importantly, the need to continually seek bridging SAFE notes is often the market signalling that the business (or its strategy) is not suited to investment or the particular class of investors they are seeking.
Despite the risk, SAFE notes can be an important and well-designed instrument for bridging investment while awaiting a near certain milestone, contract or partnership. They give founders the headroom to execute on goals and proof points that can lead to a higher priced equity round. However, when incorrectly used (especially to ‘wait for the market to recover for a better valuation’), they can become a rapidly compounding cost.
If you are thinking about raising equity, the team at One Fifteen can advise on the best equity instrument for your business. If you were interested in learning more, reach out at aidanpalmer@onefifteen.capital
