Simple agreement for future equity: an emerging trend in financing business start-ups
Statistics has it that 80 percent of startup businesses in Nigeria have failed within the first 18 months. It is however not surprising that lack of access to finance is the most common reason for the failure of these startup businesses in Nigeria. Early-stage and startup companies normally do not have access to traditional methods of securing investment. When the company is able to find an investor, it may not have the resources to pursue the long and complicated negotiation and documentation process required for traditional forms of securing capital and it may not have enough history and data to assign a value to the company. Simple Agreements for Future Equities (‘SAFE’) appears to be here to alleviate some of these issues. With SAFE, founders can procure finance from investors without going through the rigours of borrowing traditionally from financial institutions and it allows postponement of the valuation till a later date.
SAFE is an agreement between an investor and a company whereby an investor contributes a certain amount of money to the company to enable it take off; the funds are not tied to equity acquisition at the time of investment or contribution but provides rights to the investor for future equity. SAFE also differs from convertible notes because unlike convertible notes which is a debt, a SAFE is not a debt but convertible security as it does not include interest rate and maturity date, therefore SAFEs are not subject to the regulations that debt may be subject to in most jurisdictions. In SAFE, shares are not valued at the time the agreement is signed. Instead, investors and the company agree on the mechanism by which future shares will be issued for the investment made but defer actual valuation. This is effective because actual valuation may be difficult at the startup/execution stage because of insufficient data. In effect, the company undertakes to give an investor a future equity stake in the company if certain trigger events occur.
SAFE is becoming increasingly favoured by founders and early-stage investors in Nigeria for their convenience, simplicity and cost-efficiency. There is no legal framework for the operation of SAFE in Nigeria, but like every form of legal agreement, it is enforceable. Perhaps, common law positions on contractual issues may be resorted to in the event of a dispute arising out of SAFE operations.
In the emerging global economy and the development of new financial instruments to meet the ever-growing business innovations and challenges of the 21st century, common law may seem obsolete in this instance. Due to SAFE’s novel nature, the absence of regulation in Nigeria makes deter companies from its usage.
Comparatively in the United States, in May 2016, the Securities and Exchange Commission (SEC) established rules allowing investors to participate in securities-based crowdfunding as part of the Jumpstart Our Business Startups Act (JOBS ACT). Notably, the SEC notes that the SAFE conversion may be triggered by a number of different scenarios that may or may not occur in the future for the company e.g. while SAFE may be triggered if the company is acquired by or merged with another company, another may have as its trigger an initial public offering of securities by the company.
Despite the identified triggers for the conversion of the SAFE, there may be scenarios where the triggers are not activated and the SAFE is not converted, leaving the investor with nothing; for example, if a company in which you invested makes enough money that it never again needs to raise capital, and it’s not acquired by another company, then the conversion of the SAFE may never be triggered. If the conversion of SAFE is not in any way triggered by any of the events as captured in the terms of the agreement, it may appear that the Investor who had decided to invest in the business start-up would have no other option but resort to fate. Perhaps, one important feature of the SAFE agreement that may protect the interest of the Investor is often seen in the inclusion of a clause to the effect that in the event that the issuer (the Company) dissolves the business before there is a liquidity event, the SAFE holder (the Investor) may receive their investment back (often without interest) prior to any distribution to Company Stockholders, if cash is available for that purpose.
There seems to be a confusing similarity between SAFE and convertible notes, this is because both SAFEs and convertible notes convert into equity in a future priced equity. The simple difference between SAFE and convertible note is that while a convertible note can allow for the conversion into the current round of stock or a future financing event, a SAFE only allows for a conversion into the next round of financing. Although the two are all like financial instruments which can be used in business start-ups, SAFE appears to provide an all clean bill for the financial health of a Company; because SAFEs are not loans, the Company to whom the SAFE proceeds are given does not have indebtedness on its balance sheets, so the threat of insolvency is reduced.
Despite the convenience and the cost-effectiveness of new businesses opting for SAFE globally, It has been observed that many founders don’t do the basic dilution math associated with what happens to their personal ownership stakes when these notes actually turn into equity.
As much as it may be desirable, cost-effective and less cumbersome for investors to prefer SAFE to other traditional methods of raising capital for business start-ups, it is advised that the Founder consider anti-dilution protection to guide his investments, that way it becomes a win-win situation for the Investors and the Founders.
MR. TOCHUKWU ONYIUKE is a Partner in the firm of Accendolaw, Lagos