Structuring Deals — SAFEs, Convertibles and Priced Rounds
At Riptide, we place as much weight on the terms as other important factors in the investment decision. We recommend all of our angel investors understand and review the nuances of every deal they do, because often the investment terms for a financing round will make or break a deal. Below, we will explore some of the differences and benefits to SAFEs, convertible notes and priced rounds and share our preferences based on current market dynamics.
SAFEs
SAFE stands for simple agreement for future equity and was created by Y Combinator in 2013. These agreements have grown in popularity in recent years as SAFEs are contractual rights to future equity, therefore they are not debt and do not have a maturity date or interest rate associated with them. SAFE templates can be found online for free on Y Combinator’s website.
An example of a SAFE in action would be an angel investor invests $10,000 through a SAFE agreement. Typically, SAFEs include either a valuation cap or a valuation discount. The company will utilize its SAFE agreement to defer the valuation of this investment to a future raise. During this future raise, the $10,000 would then convert to equity relative to the valuation of the future priced round.
From an accounting standpoint, companies generally account for SAFEs as long term liability. This is because it requires a startup to deliver an unknown number of future shares at an undisclosed price. Thus, more solidified numbers cannot be established until performance indicators materialize.
Discount: Convertible Notes and SAFEs are helpful in early stage startups (often pre-seed and early stage) and can be structured with a discount to reward early investors for taking the risk on the company at such an early point in time. This discount gives these early investors the right to convert their investment at a reduced price to what’s paid by the next round of equity investors. To put some numbers behind it, say the price per share of the next round is $10, with a 20% discount. Early investors will then buy these shares for $8.00 therefore, early investors’ cash will buy more shares during the next round.
Valuation Cap: A valuation cap is another mechanism that is used to reward investors for taking the risks on the early stage company. If a company ends up raising money at a valuation above the “cap,” then the SAFE investor gets to convert at a share price equivalent to the cap. This means that if you go past the cap in the next raise, these initial investors are able to purchase at a lower price — they are protected in a sense for taking this early risk.
Convertible Notes
Convertible notes are another type of investment vehicle that can be utilized. It converts to preferred stock in the next round of financing. With the preferred stock conversion can come a potential increase in voting rights and/or liquidity event preferences. A convertible note is a type of debt financing thus it has a maturity and interest rate — differing from a SAFE which does not involve any debt. Similarly to SAFEs, convertible notes often include a valuation cap and/or conversion discount to help reward the early investors. Convertible notes are also higher on the preference stack than preferred equity or SAFEs, as they are a debt instrument. This means in a liquidation event, convertible note (debt) holders are paid first prior to any equity or SAFE holders.
Priced Rounds
Finally, companies will often have priced rounds for pre and post money valuations. Priced rounds are equity based investments on the negotiated value of the company. Pre-money is the value of the company before the new investors invest money. Post money on the other hand is the value of the company after the new investors invest — or to put differently, the money raised in that round. We will not dive into priced rounds in much detail. Priced rounds often require more upfront work from an accounting and negotiating standpoint but it does give companies and investors a better idea of how much their company is worth
Riptide has participated in priced rounds, convertible notes, and rounds utilizing SAFEs. With the uncertainty in the macroeconomic environment and fear in the markets, we expect early stage startup valuations to continue to decline over the next 12 months. Because of this new dynamic, we prefer to invest via SAFEs and convertible notes when possible due to the discounts and valuation caps. This enables us to feel comfortable with the potential for “down rounds” going forward. However, if there are already millions of dollars of outstanding notes or SAFEs, it may make sense to do a priced round and convert the prior investors to equity. This is just our current perspective, and it is case by case with every deal.
The Riptide Syndicate is a community of early stage investors that has joined together to leverage the network effects of our experience, perspectives, and connections. If you’re interested in joining the Riptide Syndicate or learning more about angel investing, please fill out our application form here. For companies interested in pitching our syndicate, click here to fill out our application.
Sources:
https://www.contractscounsel.com/t/us/safe-agreement
https://www.ycombinator.com/documents/
https://www.dreamit.com/journal/2021/5/27/a-founders-guide-to-notes-safes-caps-discounts-and-more
