Simple Agreement for Future Equity: Understanding The Intricacies

By Blessing Adebayo

INTRODUCTION

 Nigeria, in the past few years have notably added few colorful feathers to her cap when she began to witness the spring up of remarkable startup companies delving into various spectrum of industries and sectors, gradually unveiling the obscurity beclouding Nigeria’s participation within the corporate space. While this laudable feat deserves an applaud, it is also important that players and participants in these industries are acquainted with the rudiments involved to aid the smooth setup of these businesses and understand the risks involved if the basic principles are flouted.

One of the many problems faced by startups today is the inability to identify the startup funding stage or phase of the business and the basic requirements for that phase. How can capital be raised for the business and subsequently attract investors? Should they ask from friends? Take loans from banks? What about exploring crowdfunding? Or personal savings?

It is pertinent to note at this juncture that there are various levels of funding classified into series in the Nigerian startup space and the classifications made in accordance with the specialty and financial need of such startup. The stages are:

• Pre – Seed / Seed Funding: This is the earliest stage of capital raising process of any start-up. It involves an early investment in the idea of a project or business plan
• Series A: This refers to the company’s first significant round of venture capital financing. This is usually after the company has shown progress in building its business model and demonstrates the potential to grow and generate revenue.
• Series B: This is the second of funding for a business through investment, including private equity, investors, and venture capitalist.
• Series C: This round is focused on scaling a company’s operations and helping it grow as quickly as possible. For a company to proceed to this stage, it must have demonstrated and proven its profitability.

Startup funding during the initial stages of the startup is crucial for the company’s survival and competitive advantage. However, in most cases, startups, during such early stages do not generate revenue and they often operate in very risky business environments, thus making it difficult for investors to value such startups at the time of the investment. The above presents a seemingly choiceless situation of funding a startup using only debt financing. It is however important to note that a startup can venture into equity financing using the Simple Agreement for Future Equity (S.A.F.E), a contractual agreement not associated with the rigors of debt financing and presenting an opportunity to investors to invest in potentially profitable startups.

WHAT DOES SIMPLE AGREEMENT FOR FUTURE EQUITY REALLY MEAN?

In technical terms, Simple Agreement for Future Equity is a contractual agreement made between a company (usually a startup) and an investor, creating potential future equity in the company on behalf of the investor, in exchange for immediate cash to the company, subject to a condition precedent (an event) expressly stated in the agreement. To elucidate in less technical terms: using an example:

Mr. James is desirous of starting a company for the purpose of delivering medical supplies like blood, oxygen, drugs and rendering other medical services to hospitals in Nigeria through an application connected to those hospitals and clinics. He realized that the project is going to be capital intensive as he will need basic equipment to kickstart and ensure the smooth running of the business. James valued his expected expenses and it totaled 20 million naira, with a paltry sum of 900,000 naira in his bank account. Where will he get the remaining 1.9 million naira?

The S.A.F.E affords James the opportunity to partner with investors who will provide him with the cash needed in this instance, while future equities are created on behalf of the investors.

BRIEF HISTORY OF S.A.F.E: Simple Agreement for Future Equity was introduced in late 2013 by a U.S startup accelerator, Y combinator, ( a startup accelerator supports the early stages of growth driven companies through education, mentorship and financing, aimed at accelerating the life cycle of young innovative companies), as an alternative to traditional forms of early stage financing such as convertible notes and preferred shares, and has been used with increasing irregularity as the main instrument for early stage financing.

ELEMENTS OF S.A.F.E

To understand what Simple Agreement for Future Equity is, it is also pertinent to know what it is not. A S.A.F.E is not a debt instrument, a common stock, or convertible notes. S.A.F. Es are however similar to convertible notes in that they both provide equity to the investor during a future preferred stock round and can include valuation caps or discounts, but unlike convertible notes, S.A.F.Es do not accrue interest and do not have a specific maturity date, and, in-fact, may never be triggered to convert into equity.

1. TRIGGERING EVENT: S.A.F.Es convert into equity when an agreed “triggering event” happens, with the typical events being a qualified equity financing, a liquidity event (sale or IPO) or merger. It is important to note that the S.A.F.E is worthless if the company goes bust or if the triggering event never happens. The usual trigger is a future qualified equity investment, in which case the S.A.F.E investor gets the same type of equity that the future investors get.
2. VALUATION CAP: A valuation cap sets a maximum company value for the purposes of determining what percentage equity the investor gets, thereby solving the risks a seed-stage investor takes early on. Without a valuation cap, the percentage equity to the S.A.F.E investor keeps going down as the company’s value increases.
3. DISCOUNT RATE: A discount rate gives the S.A.F.E investor a discount off the future retail price. An 85% discount rate means the investors gets their future equity for 85% of what the future investors pay, which rewards her for the early investment.
4. PRORATA RIGHTS: also known as participation rights, prorata rights, might sometimes be given to the investors, which translates to the fact that investors can invest additional money to maintain their ownership proportion during further equity financing after the S.A.F.E investment has been converted into shares of the company. It should be noted that the presence of this element in the agreement is good for investors, but from the company’s perspective, pro rata rights can sometimes be a problem when future investors want the future round all for themselves. This potential problem can be made worse if the company has granted prorate rights to multiple S.A.F.E investors.

The fundamental premise underlying the creation of SAFE agreements is that the startup will ultimately raise additional capital. For that reason, one will find SAFE agreements most often used in seed rounds or crowdfunding offerings, where valuation is unclear. The standard SAFE will grant the investor the right to receive capital stock, typically preferred stock, of the startup at a discount to the subsequent “priced” round of financing.

CHARACTERISTICS OF SIMPLE AGREEMENT FOR FUTURE EQUITY

1. SAFEs are not common stock: Common stock represents an ownership stake in a company and entitles an investor to certain rights, SAFEs do not represent a current equity stake in the company of interest. Instead, the terms of the SAFE must be met for such investor to receive any shares in the company. A SAFE is an agreement to provide a future equity stake based on the amount invested if a triggering event occurs, such as an additional round of financing or the sale of the company.
2. Terms and rights in a SAFE: In addition to the trigger mechanism, there are a few other components of SAFEs that must be understood before its execution:

• Conversion terms. These are the specific terms by which the amount invested in the SAFE gets converted into equity.
• Repurchase rights. This is a crucial provision that every potential investor looking to invest in startups through SAFEs must critically consider. This provision allows the company to repurchase the investor’s future right to equity instead of it being converted to equity.
• Dissolution rights: This gives the investor a fore knowledge of how the money invested will be disbursed if the company ends up dissolving.
• Voting rights: As earlier discussed, SAFEs do not represent current equity stakes in the company, and so do not provide an investor with voting rights similar to common stock. But there may be circumstances mentioned in the SAFE that allows an investor voice on matters pertaining to the agreement.

ADVANTAGES OF SIMPLE AGREEMENT FOR FUTURE EQUITY

• Relatively easy to create and implement.
• Do not accrue interest as a loan does; and
• Offers flexibility in the way the company raises funds.

These three points can be instrumental in luring investors to the company. They also involve less risk that often accompanies other types of investments.  SAFEs are akin to a problem-solver for startup companies. Some of these problems are briefly addressed below:

DEBT: Debt is undoubtedly a problem for startups. It facilitates stress and can be the end of a company. As the label indicates, these companies are just starting out and trying to find a home in the market. For example, convertible notes are often used by investors, but they are debt instruments. SAFEs are not debt instruments and, as such, removes the threat of solvency. If the company fails, the owners do not have the burden of paying back the investor, but if the company succeeds, in part because it’s not burdened with lots of debt, the investor reaps the benefits alongside the company.

PAPERWORK: Paperwork is energy- and time-consuming. This is particularly problematic for startup companies because their focus needs to be on growth, scaling up and operations. When investors, for example, invest using convertible notes, maturity dates are attached to these investments. Unfortunately, many startups are usually not ready when the maturity date ripens and as a result, they must request maturity date extensions, which translates to more paperwork. With SAFEs, however, no extension is required because there is no maturity date.

STANDARDIZATION: Standardized agreements are a burden because they impose specific standards and require specific terms, clauses, or provisions. Standardization in itself is not a problem because it offers consistency and expectation, but it also denies customization. This is a problem for startups because they are unique and new to the market and customization can help them grow and develop in a way distinct from competitors. SAFEs are not standardized. Terms can be negotiated (to benefit the startup), including terms related to conversion, repurchase rights, dissolution rights, and voting rights.

CONTROL: When investors invest in startups, part of their immediate return on the investment are stocks in the company. Common stocks render voting rights to investors. With voting rights, investors can partake in the shaping of the company. However, owners of the company often want to keep control of the company’s shaping for as long as possible to make sure their vision materializes as intended. When voting rights spread out among more and more people, that control diminishes. With SAFEs, current equity stakes in the company are not provided, so the investor does not receive stocks and, therefore, does not receive immediate voting rights.

CONCLUSION

It is no gainsaying that the viability of a successful startup partly rests on its accessibility to capital, which gives it the opportunity to remain relevant in that industry. Most often than not, many startups become victims of low capital which eventually kills the business. It is therefore, important for founders and investors alike to utilize and harness the enormous advantages embedded in S.A.F.E and explore its intricacies.

Blessing Adebayo (LL. B, B.L) is a Graduate Management Trainee at Parthian Partners Limited. She can be reached at adebayoblessing41@gmail.com and +2348101563484.