Challenges for Newly Accredited Investors:

Per JOBS Act (Title II), the accredited investors are individuals who make over $200K annually or $300K as a household or have a net worth of $1 million dollars excluding primary residence. These newly accredited investors, who generally did not invest in startups, are now in a position to do so. Once they like a deal/company, there are several issues that become inhibitors to move forward:

• They are unable to determine the valuation of the early stage companies since they do not possess previous startup investing experience.
• Majority of them are not super wealthy and investing is not their full-time job. As a result, they do not have the bandwidth to get involved into deep due diligence.

The disconnect between the investors and the company founders about company valuation either slows down or derails the financing process. Even when the investors like the deal and entrepreneurs need capital, they are unable to move forward since both parties often can’t come up with mutually agreeable valuation swiftly.

“The disconnect between the investors and the company founders about company valuation either slows down or derails the financing process.”

SAFE resolves the valuation gridlock:

A SAFE (Simple Agreement for Future Equity) is a relatively new instrument that has become very popular to raise capital for early stage companies. It is being used by early pre-revenue stage startups that are difficult to valuate using traditional multipliers. SAFE allows an investor to invest capital in a company in exchange for a promise to issue equity in the future that would be priced at the valuation determined by professional investors (such as Venture Capitalists) while raising (typically Series A) the first institutional round.

SAFE allows an investor to invest capital in a company in exchange for a promise to issue equity in the future

The question in the seed investor’s mind – if I am getting the same value as the Series-A investors, what is my reward for the risk of investing at a much earlier stage? SAFE allows following provisions to reward the seed investors and to compensate for their risk:

• • Discounts: An entrepreneur can offer the seed/SAFE investors a discount off the price paid in the Series-A round while converting the SAFE into equity. The typical discount rate can vary from 10% to 20%. For example, if the Series-A investors pay $10 million in exchange for 10 million shares of a company, a seed stage investor who invested $10,000 at the earlier stage (at 25% discount rate) would get 13,333 shares (at a price of $0.75 per share) instead of 10,000 shares at the Series-A price if there were no discount.
  • Valuation Cap: An entrepreneur can offer the seed/SAFE investors capped conversion price so that the seed investors can realize upside if the company makes a lot of progress with the seed capital and secures a very attractive valuation for its Series-A round. For example, if the valuation cap in the SAFE is $10 million and the Series-A investors end up valuating the company at $20 million pre-money, then the seed/SAFE investors would get the lower valuation ($10 million) while converting the SAFE into equity and thus benefit from the significant appreciation of their investment.

Several startups offer either discounts or valuation cap to compensate for the risk of seed/SAFE investors. Some companies make it further attractive by offering both discounts and capped valuation.

“SAFE is a contract where the seed investor invest their money now and agrees to take the terms the next institutional investors (Series-A) receives with additional benefits of discounted price and/or capped valuation.”

Difference between a SAFE and a Convertible note:

• SAFE is a relatively simple instrument with a simple 5-page agreement while the convertible notes could be very complicated
• Unlike convertible notes, SAFE is not a debt instrument and it does not carry an interest rate.
• Unlike convertible notes, SAFE is not a debt instrument and it does not have a maturity date. The entrepreneur does not have to pay principal and interest back if the conversion to equity is not very attractive for investors.