Category: Crowdfunding Investors

tandard SAFE agreement showing how discount and valuation cap terms can create unintended outcomes in early-stage startup financing

Some SAFEs Aren’t Safe

On By crowdfundattnyIn Crowdfunding Investors, Crowdfunding Portals, Investor, Legal Documents, SAFELeave a comment

Why “standard” SAFE terms can produce unintended – and unfair- results.

Simple Agreements for Future Equity are used widely in the startup world, including the Crowdfunding world. My impression, however, is that almost nobody reads them, not companies, investors, or funding portals. That’s too bad, because while SAFEs are simple in theory, they can be extremely complicated and lead to unintended results. Today, I’ll describe what can happen with one variation still being used by some funding portals.

Background

We use SAFEs in the earliest stages of a company’s life, when it’s impossible to know what the company is worth. A founder creates what he believes is an incredible app and goes to the market to raise $700,000 in development costs. Looking into a rosy-colored future, he thinks his company is worth about $50 million already. His investors, aided by their snarky lawyers, think it might be worth $5 million, if everything goes right.

To bridge the unbridgeable gap, we don’t agree on a value. Instead, we issue a SAFE. The SAFE says, essentially, “We’ll wait until later to put a value on the company, when it’s farther along.” Everyone agrees that when the company raises more money in the future, in a round where the parties can agree on a price, then the early investors will get what same price as the new investors get.

Well, not exactly the same price. Because they took more risk by coming in sooner, the early investors get a better price, typically in one of two ways:

  • A Discount:  The earlier investors get a discount vis-à-vis the priced round. If the new investors buy shares for $10.00 each, maybe the earlier investors convert at $8.50 per share, a 15% discount.
  • A Valuation Cap:  No matter how much the new investors think the company is worth, the earlier investors convert at a price that assumes the value of the company is no higher than a “valuation cap” established in the beginning. Here, the early investors might have insisted on a $5 million valuation cap. If the new investors value the company at $10 million, the early investors pay half the price as the new investors. But if the new investors value the company at only $4 million, the earlier investors get that price instead.

I said that early investors typically get either a discount or a valuation cap. But sometimes they get both. In that case, when the new money comes in the SAFE holders get the lower of the price they would get from the discount or the price they would get from the valuation cap.

That’s the best kind of SAFE for investors. Unfortunately, the standard SAFE with both a discount and valuation cap can reach the wrong result.

The Standard SAFE Form Doesn’t Work as it Should

Suppose NewCo, Inc. issued a SAFE with both a discount (15%) and a valuation cap ($5 million), for $500,000. Other than the SAFE, NewCo has 1,000,000 shares outstanding. Now the company is preparing for a priced round of Series A Preferred, in which NewCo will raise $1 million. That triggers a conversion of the SAFE.

NewCo and the new investors agree that NewCo is worth $4 million immediately before the investment. That means that immediately following the investment, the new investors should own 20% of the stock ($1 million investment divided by $5 million post-money valuation). All that’s left is some simple arithmetic to decide how many shares they should receive for their 20% interest.

They should get that number of shares such that, if NewCo were sold for $5 million the next day, they would get exactly their $1 million back.

To calculate that number, we need to calculate how much all the other shareholders would get, including the SAFE holders.

Given the structure of the SAFE, where the holders get the better of X or Y, you might think the standard SAFE would say that upon a sale of NewCo, the SAFE holders receive the higher of the amount they would receive from the discount and the amount they would receive from the valuation cap. But it doesn’t. Instead, it says they will receive the higher of the amount they paid for the SAFE or the amount they would receive from the valuation cap. The discount is nowhere to be found.

In this case, because the valuation cap is higher than the new valuation, the SAFE holders would receive their $500,000 back, nothing more. The other stockholders, who own 1,000,000 shares, will get $3.5 million, or $3.50 per share. And the new investors, to get their $1 million back, should get 285,714 shares of the new preferred for $3.50 each.

Upon a conversion, the SAFE holders receive the better of the number of shares they would receive under the valuation cap and the number of shares they would receive under the discount. Because the $5 million valuation cap is higher than the new valuation, the SAFE holders will get the number of shares under the discount. The share price for the new investors is $3.50, so the conversion price for the SAFE holders, with a 15% discount, is $2.98. Having invested $500,000, they receive 168,067 shares.

The fully diluted cap table now shows:

OwnerSharesPercentage
Original Stockholders1,000,00069%
New Investors 285,71420%
SAFE Holders168,06712%
TOTAL1,453,781100%

Here’s how a $5 million selling price would be divided based on those percentages:

OwnerPercentageConsideration
Original Stockholders69%3,439,308
New Investors 20%982,658
SAFE Holders12%578,034
TOTAL100%$5,000,000

As you see, the new investors get less than they’re supposed to, the original stockholders get less than they’re supposed to, and the SAFE holders get the difference. And that’s not because the SAFE is ambiguous. It’s because that’s how the SAFE was written.

Although Y Combinator no longer uses that SAFE, many still do, including funding portals like WeFunder. 

What Do We Do Now?

If you’re the new investors, you don’t do the deal unless someone makes you whole.

If you’re the SAFE holder, you hold your ground or, if you really want the investment, you negotiate with the existing stockholders.

If you’re the existing stockholders, you try to talk reason to the SAFE holders. That’s not how it’s supposed to work!

If you’re the unlucky founder and own only a chunk of the 1,000,000 shares already outstanding, you’re squeezed. To make the new investors whole on your own, you’ll have to give up 5,042 more shares to the new investors, on top of the shares you’ve already transferred to the SAFE holders because of the structural flaw in the SAFE.

What Do We Do in the Future?

If you’re the company or funding portal, you correct the standard SAFE.

If you’re the new investor and see such a SAFE, you don’t spend a lot of time until the existing stockholders and the SAFE holders figure something out.

If you’re investing in a startup and are offered such a SAFE, you say, Sure! 

Questions? Let me know.

Markley S. Roderick
Lex Nova Law
10 East Stow Road, Suite 250, Marlton, NJ 08053
P: 856.382.8402 | E: mroderick@lexnovalaw.com

Think Twice Before Giving Crowdfunding Investors Voting Rights

On By crowdfundattnyIn Crowdfunding, Crowdfunding Investors, Investor, Investor DisclosuresLeave a comment

I attend church and think of myself as a kind person, yet I discourage issuers from giving investors voting rights. Here are a few reasons:

  • Lack of Ability:  Even if they go to church and are kind people, investors know absolutely nothing about running your business. If you assembled 20 representatives in a room and talked about running your business, you would (1) be amazed, and (2) understand why DAOs are such a bad idea.
  • Lack of Interest:  Investors invest because they want to make money and/or believe in you and your vision. They aren’t investing because they want to help run your business.
  • Irrelevant Motives:  Investors will have motives that have nothing to do with your business. For example, an investor who is very old or very ill might want to postpone a sale of the business to avoid paying tax on the appreciation.
  • Bad Motives:  Investors can even have bad motives. An unhappy investor might consciously try to harm your business or, God forbid, a competitor might accumulate shares in your company.
  • Lack of Information:  Investors will never have as much information about your business as you have. Even if they go to church, are kind to animals, and have your best interests at heart, they are unable to make the same good decisions you would.
  • Drain on Resources:  If you allow investors to vote you’ll have to spend lots of time educating them and trying to convince them to do what you think is best. Any time you spend educating investors is time you’re not spending managing your business.
  • Logistics:  Even in the digital age it’s a pain tabulating votes from thousands of people.
  • Mistakes:  When investors have voting rights you have to follow certain formalities. If you forget to follow them you’re cleaning up a mess.

I anticipate two objections:

  • First Objection:  VCs and other investors writing big checks get voting rights, so why shouldn’t Crowdfunding investors?
  • Second Objection:  Even if they don’t help run the business on a day-to-day basis, shouldn’t investors have the right to vote on big things like mergers or issuing new shares?

As to the first objection, the answer is not that Crowdfunding investors should get voting rights but that VCs and other large investors shouldn’t. The only reason we give large investors voting rights is they ask for them, and our system is called “capitalism.”

Before the International Venture Capital Association withdraws its invitation for next year’s keynote, I’m not saying VCs and other large investors don’t bring anything but money to the table. They can bring broad business experience and, perhaps most important, valuable connections. A non-voting Board of Advisors makes a lot of sense.

The second objection is a closer call. On balance, however, I think that for most companies most of the time it will be better for everyone if the founder retains flexibility.

To resolve disputes between the owners of a closely-held business we typically provide that one owner can buy the others out or even force a sale of the company. Likewise, while we don’t give Crowdfunding investors voting rights we should try to give them liquidity in one form or another, at least the right to sell their shares to someone else.

Give investors a good economic deal. Give them something to believe in. But don’t give them voting rights.

Questions? Let me know.