The information contained in this article is not new to most founders, however, the perspective explored in this article is quite different. This article aims to help you erase any yellow flags, which some people might consider red flags.
As you go down the safe route, this would help two groups of people;
- The group who are unaware of which one to do. This article will help you make up your mind.
- The other group already has their mind made up with the decision to go down the safe route. So what this does for them is that it shows them some of the risks that they should be aware of and why even though it’s called safe, it’s not always a safe option.
I’ll explain the Equity round, Convertible round, and Safe round, and then we will go through comparisons or the yellow flags.
Equity Round
An equity round is where a Founder goes to an investor and says to the investor, ‘I’m doing something great and I need some money to move me to the next level If you can give me that money, I will give you a percentage of my company. In other words, we become co-owners of this company.’’
The investor says in return, ‘I like what you’re doing so, I’ll give you X amount. What percentage of your company do you want to give me?’ And the founder says, I’ll give you 5%. They negotiate on things like – what does it give me? What are the benefits? Do you have a director? Can I direct the company? Do I sit on the board? What shares do I have? How often am I going to get your reports? Are they going to be monthly, quarterly, or annually? How often are you going to have an AGM? Would it be quarterly, twice a year, or once a year? After these conversations, you give them part of your company and then they become co-owners.
There is a need to understand these things by going through the whole process. Usually, both parties get their lawyers involved, your lawyer talks to their lawyer, there is a bit of back and forth, and eventually, you settle on something. However, this depends on what stage you are in as an organization, if it’s a very early stage startup, you may not have a lawyer or even afford the services of a lawyer to do all the back and forth. On the other hand, you may not understand most of it because it can be very technical and legal. The process in its entirety can be a bit stressful, but when done, it’s the neatest form of transaction. For example, if you owned 100% of your company before you went in for those conversations, by the time you come out of it, you might own 95% of your company and everybody knows that so, the investor now owns 5% while you own 95%. It is clear! Everyone knows that. So that’s an equity round.
However, that’s not traditionally how things have always been done – give me some money; I’ll give you some shares. As things started progressing, we got to know what you call convertible notes.
Convertible Note Rounds
What this means is rather than just give you some money, and you provide me with equity, what the convertible note does is that it is more of debt so; which means you are borrowing money.
As a founder, you tell the investor to borrow your money. You’re not telling him to buy shares, you’re telling him to borrow you some money which you will pay back on a monthly, quarterly, OR Annual basis with interest for some time, usually a year, eighteen months to three years. There is usually a period which is called a coupon rate – this is the interest rate that the investor will charge the founder at the end of the tenure. So, for example, if I gave you $100,000 and you have paid me interest for the period of 18 months. Now, at the end of 18 months, I have two options as an investor; the first option is that you give me back my 100,000 Naira or I collect my 100,000 Naira from your $100,000, so, with option number one, we shake hands, and everybody goes their separate ways. The second option is, I’ll give you this $100,000 to put in your company which will add a lot more value to your company. By the time you give it back, the interest rate you pay me is quite small, because you can’t charge a startup a high-interest rate so the interest rate will usually be very low. The investor feels it’s very unfair that; you use my money to build your startup, and you’re now worth maybe 10 times more than when I put my money in and you just go. Now, what you do is to have a second option which is: If at the end of the 18 months, I see that you’re putting the money to good use, or you’re adding more value to your company with my money, then I have the option to convert the loan to equity. What usually comes as a result of this is that you now have the discount rate. So for example; your startup is worth $1 million and I gave you $100,000. In 18 months, your startup is now worth $5 million and you want to sell – you’re selling equity at $5 million or you’re doing an equity round of $5 million. You cannot sell it to me at the same rate as everybody else. So what is usually agreeable at the beginning of the convertible note is a discount rate i.e. this is the discount I’ll give you if you decide to convert. Not equity notes though, some convertible rounds don’t have that, depends on the founder or it depends on the investor. What you typically do is have a discount rate; it could be 10, 20, or 25%. It depends on what it is or however much it’s been sold, the equity at the time is that they will give you a discount because you came in early. So, for a very long time, we’ve always had one of those two options either an equity round or a convertible note route. However, the startup ecosystem globally just accelerated it tremendously and there were a few challenges like I addressed earlier; where the legal work and the back and forth that needs to happen before everybody. It will just take too much time.
Safe
Y Combinator introduced the safe note in 2013. This means a simple agreement for future equity. It is very similar to the convertible note, let’s just call it an upgrade of the convertible note. But what they did, was to make it founder friendly because they felt that it was too much pressure on a founder trying to do all of this thing. The idea is to make this agreement as simple as possible by removing the interest rate from the convertible note.
First is the vesting date, did you know that interest is too low? It’s not
the kind of interest that an investor wants; ultimately, the investor wants equity. So what’s the point of having an interest?
Also, on a convertible note, your timeline could be 18, 24, or 36 months, but there has to be a timeline that signifies an end date of the agreement. However, what YC did was to remove that end date so there’s no timeline anymore. The end of this agreement will be determined when you do an equity round. It is the equity round that ends the safe agreement. If there is no equity round, then the safe agreement is intact and it could stay that way for years. Some people have had their safe agreements for over 10 years and the startup hasn’t done any equity rounds. This shows one of the disadvantages of safe because what is happening is that the startup received a policy for safe, collected money, but has not essentially got an equity route.
YC also introduced two things to help the investor. First, there will be a valuation cap for you. This means that if I give you $100,000 today and you give me a valuation cap of $5 million, wherever you do your equity round (which could be in six months, one year, or 10 years), there will be a maximum valuation for me as an investor. Even if you assign it to everybody at a $10 million valuation, you will sell to me as your early investor for 5 million if that is the valuation cap that you initially agreed to. In that scenario, the great thing is that the investor is getting a discount of 50%. But, you have to be worth at least 5 billion for the investor to take advantage of that or your valuation has to be a lot more than 5 million. However, you have two options for situations where your valuation is not more than 5 million or just over 5 million when there’s no real advantage for the investor. What you can add to that is a discount rate, for instance, you can offer a valuation cap of 5 billion or a 20% discount, so the investor can choose which one he wants.
There are three main things that founders or investors need to be aware of when you’re considering a safe;
- how much is the safe round? How much do you need to raise?
- The second one is; what is the valuation cap? If there’s going to be a valuation cap, what is that valuation cap?
- What is the discount if there’s going to be a discount?
Y Combinator also created a legal agreement based on United States law and created a legal agreement that has become a template. This is because, from their perspective, most of their investors are based in the US so, anywhere in the US you can pick up that agreement and you don’t need to negotiate anything or do anything. It is a simple agreement.
Benefits of safe business equity for founders
- This safe approach allows the founder to delay the negotiation of valuation and terms. One of the biggest issues if you’re doing an equity round is valuation because the investors will hardly agree on the valuation of the company. For instance, if a founder says, he or she is worth 1 million, the investor says I think you’re worth 200,000 so, where do you meet? How do you go down to 200? This can cause tension between the investors and founders. One of the great deeds we found out that SAFE does is that you don’t need to have that valuation compensation anymore BUT; you need to have the valuation cap conversation about what you would do when completed. In this case, the conversation could go like this: my company is worth $1 million today, give the $100,000. In 18 months, I can guarantee you this company is going to be worth at least $5 billion. It’s going to be worth a lot more than $5 million but because you’re giving me this 100k, I will cap the valuation for you at 5 million.
Now, It’s you who knows, I don’t know, sometimes they thought it would be straightforward but logically, so I’m saying instead of saying that our job is, worth five million today, what I’m now thinking is Okay, is that a good move? Or is it 5 million, in five years? So they put an arbitrary number, because, what’s the timeline you want to use? Whatever, I’m going to make my money back. I can’t be sitting on my money forever, right? So you say to yourself; in five years, you know, we’ll just be worth 5 million. And if you feel your job will be worth 5 billion in five years, at least 5 million in five years, then you can tell or begin to say okay, we’ll be at our best. So while you’re not necessarily doing that illegal negotiation about equity and valuation, technically the background. so that’s one of the key differences. And that’s one of the reasons why founders will go to SAFE. Because, you don’t have to deal with, the valuation question.
- Another reason is that they also don’t need to pay you interest. So they find that those repayments are on a budget and the returns on interest are notable so thankfully, the SAFE removes that.
- Also, there is no timeline so they’re not under pressure. What usually happens is, that if you had a one-year timeline, you could do what you want to do for Exports labels. So, you’re not under pressure to return the investor’s money should he request it anytime.
- It’s much quicker to execute because it’s a standard template. All you need to do is review that template which, most startup lawyers know already today. So most times, when they are reviewing, they don’t review the terms, they just review the numbers – how much am I giving you? What is the discount rate? What is going to be the valuation cap? They will like to know when you will raise equity but that doesn’t go into the contract. In recent times, what people add to the SAFE is
that if by X amount of time, if you haven’t done that equity Round, I have the right to convert my SAFE to equity. This is what some investors are obligated to do but that was not the point of a SAFE. However, there’s no pressure of giving back, there’s only pressure of converting.
- There’s not much legal back and forth for a safe, you don’t necessarily need a lawyer, even though I wouldn’t advise the founder to sign a safe without getting a lawyer to see it. But generally, you can go outside the safe without a lawyer because their terms and conditions are there, everybody knows that you can just agree because it’s a big advantage for founders as you don’t have that equity conversation. Immediately you are removing the risk of selling your startup for cheap, use the 1 million versus five. Invariably, what you are doing is instead of selling your equity at 1 million valuations which you would have done if you were to sell today, what you’re doing is you’re still getting the money but you are really selling it at a 5 billion valuation if that’s the valuation cap. The investor will never get that 5 billion until that 5 billion materializes but, you sold it to him for 5 billion today. That’s a very clever thing for founders because most investors treat the valuation cap as the valuation, even though it is not for today, it is for the future but nobody knows where the future is. So it’s a big plus for founders.
- The final one is that SAFE notes give founders a faster way to raise money in early rounds of funding. For an equity round, sometimes you could spend up to three months negotiating but the case is different for a SAFE. For example, one of the quickest I’ve done is one week.
The reason for this article is to draw what the pitfalls of SAFE are and why founders should be very careful.
- The first thing is the African context which is the risk. Startups encounter risks but in Africa, there are a lot more risks. So, the challenge that you may find as a founder is that in a very risky environment, SAFE may not necessarily be the best thing because it could cost you some reputational damage. If you’ve told somebody to give you money in return for equity, at some point, there’s an element of trust there that you will give them. So while it might be easy for you to take the money, there is that element of trust that needs to be met. So generally, I would advise against SAFE particularly, if you’re honest with yourself as a founder, the risk associated is quite significant.
When people decide SAFE, there’s a different interpretation, the affiliate investor feels they are really part of the business because you don’t have shares in the company yet so, unless, again, it’s still up to you the founder to make them as engaged as you want them to be. But I’ll just say, look out for that.
- The second problem with SAFE is that it depends greatly on the stage at which your startup is because what you find is that, it could be damaging to you in the future. A lot of investors don’t like to invest in startups that have a few safes route.
