What is SAFE? The SAFE – Simple Agreement for Future Equity – has emerged in the South African investment environment as a buzz word. Introduced in December 2013 by a Silicon Valley seed funder, the instrument is gaining traction in South Africa as a means of raising seed capital and growth finance for start-ups. In traditional lending and investment models start-up founders often find themselves losing or compromising flexibility in running their businesses. Generally, an investor has a right to influence and participate in business decisions. Loan finance may require debt repayments irrespective of the cash flow position of the business and debt conversions to equity may have little correlation to the underlying value of the business.
How does SAFE work? An investor will pay the start-up company an amount of money in exchange for a future, contingent right to acquire equity in the company upon the happening of a “Conversion Event“. There is no “deadline” by when the Conversion Event must happen and, until it occurs, the investor acquires no rights to equity in the company, or to have their investment repaid.
The terms of the SAFE are contained in a standardised template document, the intention being that start-ups and investors will not have to spend time and money negotiating and drafting bespoke and complicated legal documents. The SAFE shares many similarities with a “convertible note”, although unlike a convertible note, a SAFE has no maturity date and is meant to be classified as “equity” rather than “debt” in a company’s books. However, in practice, applying the principles of IFRS, there is uncertainty as to the treatment of the instrument and whether it should be classified as debt or equity.
Conversion Events: when does a SAFE terminate?
The SAFE expires and terminates in three instances, namely, an Equity Event, a Liquidity Event or a Dissolution Event.
Equity Event – where the start-up raises capital by issuing so-called “Preferred Stock” (preference shares) to third parties. The Equity Event will trigger an automatic issue to the SAFE investor of a number of preference shares. The number of preference shares to be issued to the SAFE investor is determined using an agreed formula based on an agreed “Valuation Cap“. The Valuation CAP is the pre-determined value of the company used to calculate how many preference shares will be issued to the SAFE investor when the Equity Event happens. The aim of the Valuation Cap is to prevent investor dilution if the company experiences substantial growth in value after the SAFE investment. The investor would typically want the Valuation Cap to be as low as possible to maximise the opportunity to convert his SAFE investment to more equity in the future. In some cases, a SAFE investor may be able to negotiate a discount, on top of the Valuation Cap, on the price per preference share to be issued to him on the occurrence of an Equity Event.
Liquidity Event – an Initial Public Offering or Change of Control (business sale, share sale or merger). The SAFE investor may elect to either be repaid his investment in cash or to convert the SAFE into a number of ordinary shares, calculated with reference to his initial investment amount and the agreed Valuation Cap. An investor will make a decision based on the terms of the Liquidity Event transaction – cash or conversion may be more advantageous in different circumstances.
Dissolution Event – ceasing trading; voluntary or involuntary general assignment for benefit of creditors (which seems equivalent to a compromise with creditors); liquidation, dissolution or winding up. In the South African context, thought must be had as to whether business rescue proceedings should constitute a dissolution event. The investor will be repaid his investment amount in cash. The investor is to be paid before any assets of the Company are distributed to ordinary shareholders.
Is SAFE attractive to investors? If there is an Equity Event, the terms of the shareholding issued to the Investor will be materially the same as for all other preferred shareholders. The investor will have no input or say in what these terms will be, this being negotiated by the company and the new investor at the time the preferred shares are offered.
There is no deadline fixed for when the Equity Event must happen. The investors may wait indefinitely for the Equity Event to happen so as to convert their capital investment into equity. The SAFE is not seen as a loan, which means there is no fixed term for repayment, or any provision for interest.
A potential risk for the investor is that, rather than triggering an Equity Event, the start-up may issue an unlimited number of SAFE instruments. The investor may consider imposing a limit on the number of SAFEs that a start-up is allowed to issue. This might be difficult for a start-up to commit to, without knowing in the early stages the level of investment that may be required.
Why a SAFE is attractive to an investor is that it will give the investor an opportunity to invest seed capital in a start-up with the potential to enjoy huge up-side in the growth of the company, without complicated legal agreements and structures.
How does a SAFE help a start-up? The SAFE is designed to be a standard form template instrument, allowing the parties to effectively “plug in and play” which allows the transaction and funds to be invested quickly.
The SAFE is not intended to be seen as a loan. Interest doesn’t accrue and there is no fixed a maturity date. This is intended to assist the start-up’s balance sheet position. However, as set out above, in practice, applying the principles of IFRS, there is uncertainty as to the accounting classification of the instrument. Since there is no deadline for repayment, and because the investor is not considered a creditor, as is the case with debt instruments, the risk of insolvency in the event of non-payment or non-conversion to equity is removed.
Some final observations. The template SAFE documents are constructed in the context of the legislative and commercial environment of the United States (US). Concepts easily understood and dealt with in the US may be dealt with differently in South Africa. Thus the SAFE would need to be carefully considered in the context of South African law.
Parties concluding a SAFE may of course amend the document to cater for their unique requirements or to build in extra protections. However, this may defeat one of the main purposes of having a standard form instrument, which is to limit the aspects to be negotiated and to mitigate against time delays and cost factors. One of the most attractive aspects of the SAFE is that it is a simple, standardised investment document which can be used by start-ups at the early stages of building a business to raise money. Without the complicated structures usual with traditional equity and debt capital raising models, the SAFE can offer a quick, simple, cost effective access to investment.
Juliette has an LLB from UCT and was admitted as an attorney in 2011 after completing her articles at Bowman Gilfillan. She then took up a position as an associate at ENS’ corporate commercial department where she practised until September 2013 when she left and joined Caveat Legal. Juliette specialises in corporate commercial and technology related work.
Danielle has an LLB from KZN and was admitted as an attorney in 2007 after having completed her articles at Cox Yeats. She rose to the level of director there before moving to ENS and then Glyn Marais, where she practiced in the commercial department. Danielle joined Caveat Legal in 2015.