Everything in Silicon Valley moves to keep pace with the speed at which business and entrepreneurship evolves and adapts. As a result, the legal and transactions infrastructure is forced to match this development by using increasingly innovative transaction documents.
An example of this is the SAFE agreement. Pioneered and made popular by the famous Y Combinator, the SAFE Agreement — an acronym for Simple Agreement for Future Equity — represents the evolution of the much-favoured convertible note.
The South African entrepreneurial ecosystem, whilst a bit behind the pace of San Francisco, has a habit of adopting these trends and applying them, right here in Mzansi. The SAFE agreement is no exception.
However, a word of caution — simply adopting a US template and applying it to your company can create some undesirable consequences.
To keep pace with innovative financing mechanisms, it’s important to be familiar with the salient features of a SAFE agreement.
Briefly, these are:
- Unlike a convertible note, the SAFE is not a debt instrument and so, it wouldn’t traditionally attract interest
- It seeks to mitigate the risk of insolvency for the Investee and does not have a maturity date
- It’s intended to be a simple, standardised document to cut down on transaction costs, negotiation time and provide an easier way for businesses and investors to agree on a neutral document to regulate the advancement of funds.
Typically, an investor would advance funding, in exchange for a future, contingent right to acquire equity in the business, upon the happening of pre-agreed ‘trigger events’, such as:
- Equity Financing: For example, where the Investee company raises capital in exchange for equity
- Liquidity Event: May occur upon a change of control or an IPO
- Dissolution Event: When the company voluntarily ceases to trade and/or is liquidated. One would have to regulate whether business rescue proceedings constitute a dissolution event in SA.
When one of these trigger events occurred, the investor would acquire the right to purchase shares in the company at a pre-agreed ‘valuation cap’ or a discounted valuation to the actual value of the company.
The valuation cap attributes a pre-agreed, but notional, value to the company that will be used in the calculation of how many shares the investor will purchase. For example:
Investor A invests R1 million into Investee Company B at a valuation cap of R10 million. At the Trigger event, the actual valuation is calculated to be R20 million. Accordingly, Investor A will purchase shares equivalent to a R1 million equity purchase in a R10 million company, despite the value of the company actually being R20 million.
This translates into relatively more shares in Company B, than if purchased at the actual valuation — a win for the investor and just reward for taking a bet on a speculative business.
An alternative is the ‘discounted valuation’ method, which arises where the investor agrees with the investee company to discount the real value of the company at the trigger event, by a pre-agreed percentage.
In the example above, where Investor A agrees with Investee Company B to invest R1 million at ‘valuation less 20%’, he would get more preference shares than if he had invested R1 million at the actual valuation.
A further alternative is a hybrid of both the discounted valuation and the valuation cap, where the investor is able to choose either scenario, depending on which would yield the greater number of shares.
It is worth remembering this about SAFE agreements:
- The business is free to issue as many SAFE agreements as it pleases, unless this is specifically regulated
- There is no uniformity on the treatment of the SAFE as a non-debt instrument and has not, to the best of my knowledge, been tested by International Financial Reporting Standards
- The SAFE provides for the subscription of shares on a substantially similar basis to that of other shareholders, but the investor has no way of knowing those terms, unless specifically regulated in the document
- There is no maturity date, so the investor could wait indefinitely for the trigger event to occur.