Is it all in the name? Fundraising with SAFE notes

A relatively recent development in the world of fundraising for start-ups has been the use of “SAFE” (Simple Agreement for Future Equity) instruments. Y-Combinator, a seed funding platform based in Silicon Valley, claims to have developed it as a (potentially) standardised instrument and as an alternative to convertible notes, which can save companies and investors money and time. While increasing in popularity in the US market, their use in Australia has been infrequent and can result in quite complicated versions of the original simple instrument. The interesting question for the Australian market is: will start-ups and their investors find such instruments attractive?

SAFE notes have certain common features including:

• no interest rate
• no maturity date
• automatic conversion into equity on a future fundraising round
• a cap on the valuation of the start-up company for the purpose of converting the SAFE note into equity

A SAFE note is not a debt instrument. Similar to a warrant, it is an agreement between investor and company where, in consideration for cash, the investor receives a right to acquire shares in the company in a future equity round. Consequently, SAFE notes do not give rise to issues of insolvency for the company (where the repayment obligations may be problematic for a start-up) nor do they have the potential complexity around alternate debt funding (for example where a subordination deed might be required to address existing creditors and their security interests over the company).

Variations of a SAFE note might include a discount toggle (with or without a valuation cap) or a MFN provision (with no valuation cap or discount).

Our experience with SAFE notes in the Australian start-up marketplace has been mixed. The obvious concern is that, whilst simplifying the capital raising process (particularly given the relative simplicity of the documentation), the investor has no control over the timing of the capital raising and conceivably the ‘conversion’ of the contractual right to equity may not occur for a substantial period.

Various questions spring to mind when considering investing in a SAFE note.

What happens if the pre-money valuation for a future round is higher or lower than the valuation cap?

In Australia, some SAFE notes do not provide for a valuation cap at all and instead simply apply a discount to the issue price for that equity round. However, where a valuation cap is provided for, the number of shares issued to a holder would typically be the higher of the subscription amount paid for the SAFE note divided by:

• the SAFE note price (ie. the valuation cap amount divided by the fully diluted share capital of the company, excluding other SAFEs and convertible notes); or
• the issue price for that fundraising round.

In other words, the valuation cap ensures that the investor is protected in circumstances where the company’s market value exceeds the valuation cap.

What happens if the priced equity round never occurs?

Typically, you would expect a growing business to have additional capital requirements beyond the seeding stage. However, circumstances can occur where the founding shareholder(s) elect to exit the business or the start-up simply fails to grow (or becomes insolvent), in which case a SAFE note does offer investors some protections.

If a liquidity event occurs in the form of a change of control, IPO or sale of business of the subject company, the SAFE note holder may elect to receive either a return of their initial investment in the SAFE note or shares in the company according to their fair market value.

If an insolvency event occurs SAFE note holders would rank ahead of equity holders on a return of their investment.

Put simply, because a SAFE has no maturity date, it can remain on foot for a substantial period of time. It should only expire/terminate at the earlier of when the holder receives cash or shares.

Will SAFE notes become commonplace in Australia?

The use of SAFE notes by start-ups in Australia has been modest to say the least. This appears to be largely due to our smaller and more conservative market, relative to the United States. SAFE notes sit fairly comfortably in the current Australian regulatory environment because they are not securities per se but rather contractual rights and therefore do not attract the same level of scrutiny as equity. However, Australian investors seem more comfortable with the greater protection that comes with convertible debt instruments and our expectation is that this will continue for the foreseeable future – at least for the short to mid-term.

Authored by:
Edward Nixey, Partner
Richard Partridge, Partner