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Seed Financing 101: Understanding SAFEs and Convertible Notes for Tech Startups

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Welcome to Part 3 of our series, Legal Fundamentals for Canadian Technology Startups. We're here to offer a pragmatic, legal roadmap for launching your Canadian tech startup. Be sure to check out Part 1 Exploring Business Structures for Canadian Tech Startups: Sole Proprietorship and Partnership and Part 2 Exploring Business Structures for Canadian Tech Startups: The Corporation.

 

Introduction

In the dynamic realm of tech-enabled startups, securing financing is a pivotal driver for expansion, especially when innovative ideas surpass available capital. The initial funding phase, often termed the "seed" round, establishes the groundwork for subsequent financing rounds like "Series A," "Series B," and beyond (terminology variations notwithstanding, a "seed" round in this article denotes a startup's first formal financing stage). This discussion delves into the two prevalent legal instruments for seed stage financing: the SAFE and the Convertible Note. Additionally, it examines a crucial term within these instruments: the Valuation Cap.


The Valuation Problem for Startup Financing

In many industries, financing typically follows the paths of either debt or equity. Debt manifests as loans, lines of credit, or bonds and debentures, while equity is commonly represented by shares, whether common or preferred. However, in the unique landscape of seed financing for tech-enabled startups, these traditional avenues are not viable due to the challenges posed by the valuation problem.


In conventional finance and accounting, valuation of companies are typically evaluated using established methods, such as assessing earning multiples, determining the fair market value of assets, or considering the value of industry competitors. However, early-stage startups, often operating in pre-revenue stages and lacking substantial assets, face challenges, especially in markets without established industry benchmarks. This makes traditional valuation methods impractical, creating difficulty in "pricing" the company to a level where it can attract traditional debt and equity financing. To tackle this valuation problem, the startup industry has chosen a deferred approach. Valuation is postponed until the startup reaches a stage where it has developed adequate revenue, assets, or competition to establish a meaningful valuation. This deferral is facilitated by relying on two key financing instruments for seed financing: the convertible note and the SAFE.


The Convertible Note

A convertible note functions as a hybrid legal instrument, blending characteristics of both debt and equity. It embodies debt traits with a maturity date, interest accrual, and a principal amount, and yet, it transitions into equity by converting into company shares at a future date. This conversion is typically linked to a liquidity event such as a priced equity financing round, the sale of the company, or an initial private offering (IPO).


The convertible note, in effect, defers a formal evaluation until a later time while allowing for investment in the corporation. Convertible notes allow the investor the ability to “lock in” a conversion formula for their investment that will yield a better conversion price for the investment than if those same investors invested their money in the “priced” rounds (more on that idea below).


For founders, a convertible note facilitates faster, cheaper, and more flexible access to financing compared to raising funds during a priced round, which normally require issuing preferred shares. It also ensures that investors do not become shareholders until the instrument converts to shares, reducing administrative and legal burdens for the company until later stages.


Terms of convertible notes vary significantly based on the company, investor, and legal counsel involved. Sophisticated investors often have their own standard or precedent convertible notes, which include terms related to interest, conversion to equity, security grants, representations and warranties, permissible amendments, and additional investor rights.


SAFEs

The second prevalent legal instrument in seed financing is the Simple Agreements for Future Equity (SAFE), introduced by Y Combinator and widely adopted in the United States and Canada for seed-stage financing.


Designed with startup friendliness in mind, SAFEs differ from convertible notes by functioning neither as debt nor equity. Instead, they operate as promises for future equity, contingent on terms outlined in the SAFE. Investors inject capital into the startup, receiving a commitment of future equity upon the occurrence of a future equity financing (i.e. a Series A round) or another liquidity event, such as the sale of the company. Similar to convertible notes, the valuation of the company isn't mandatory at the time of SAFE issuance.


SAFEs boast several advantages. Their standardization reduces legal fees and negotiation costs for both investors and startups. They require less documentation and can be closed individually rather than simultaneously with multiple investors. Moreover, as non-debt instruments, SAFEs lack maturity dates or interest rates, allowing startups to grow without the pressure of repaying debts by specific deadlines.


Valuation Caps and Discount Rates

As we delve into the intricacies of seed financing, one may question why investors would willingly embrace the risk associated with early-stage startups, where an estimated 75% of financing may not yield positive returns. The answer lies in the intentional design of mechanisms like valuation caps and discount rates, offering tangible benefits for early investors despite the inherent risk.


Valuation Cap

The valuation cap is the most important term in the SAFE and the Convertible Note. Valuation caps could also be the most complicated term of seed financing. A valuation cap sets the “maximum valuation – for the purposes of determining the price per share – at which an investor’s money converts into equity, even if investors in the priced round agree to and pay a different price per share based on a higher valuation.”


The impact of a valuation cap can be intricate, influenced by factors such as whether the convertible note or SAFE is based on a pre-money or post-money basis, the number of investment rounds for these instruments, and the presence of an option pool or issued options under a stock option plan.


An example will help illustrate how the valuation cap functions. Imagine that X Ventures invests $200, 000 into Startup Y, and they agree to a valuation cap of $2M with a SAFE. At the Series A round of financing, Startup Y raises an additional $1 million from VC Z. The only outstanding equity going into the Series A round are 900,000 common shares belonging to the founders of Startup Y.


To simplify our discussion, let's focus on the impact of the valuation cap immediately after the SAFE converts and before the Series A round by VC Z. This will provide a clearer understanding of the effects of the valuation during this specific timeframe.


Imagine the pre-money valuation ends up being $4M at the priced Series A round and no valuation cap existed for X Ventures. In this example, X Ventures investment of $200, 000 would result in 5% of equity ($200,000/$4,000,000) or 47,368 shares ((900,000 / 95%) – 900 000).


However, let us bring the valuation cap into consideration. With a valuation cap of $2M, X Ventures will now receive 10% equity ($200,000 investment /$2,000,000) or 100,000 shares ((900,000 / 90%– 900 000)).  The valuation cap provides the investor with a premium of around 50, 000 shares!


If that difference isn't shocking enough, let's now assume that the pre-money valuation was actually $20M at the priced Series A round. With the valuation cap, X Ventures still receives 10% equity or 100,000 shares. However, without the valuation cap, X Ventures would only receive 1% of the equity or 9,090 shares. The valuation cap provides X Ventures with 9% or nearly 100 000 more shares in Startup Y!


Discount Rate

A discount rate is another option that investors used to mitigate the risk of investing early into a startup. A discount rate is less complicated than a valuation cap. A discount rate is applied against the share price provided to equity investors in the financing in which the SAFE or Convertible Security converts (often times Series A).


A simple example will demonstrate the application of the discount rate. Suppose X Ventures invests $10,000 into a SAFE with a discount rate of 80% for Startup Y. Now assume that VC Z invests $10, 000 in a Startup during the Series A round where the shares are offered at $10/share.


VC Z will receive 100 shares in the company ($10,000/ $10). X Ventures will receive 1, 250 shares ($10,000/0.8&$10). X Ventures receives 250 additional shares or 25% more equity than VC Z.


Considering the advantages the valuation cap offers to the investor, it is advisable for the founder to explore negotiating a discount rate. Alternatively, maintaining the valuation cap at the highest possible level is also a strategic option.


Conclusion

Seed financing for tech-enabled startups is an important milestone, and the SAFE and convertible note represent the most common legal instruments used to raise capital at this stage. These instruments provide founders with a nuanced approach to securing capital, balancing the need for speed, cost-effectiveness, and flexibility. However, due to the effect of the valuation cap, founders must be very careful not to dilute their ownership stake when negotiation and agreeing to financing.


Andrew Roy Legal helps tech-enabled startups with every stage of their journey from incorporation to IPO. Contact us today to learn more about how we can assist you.



This article is intended for informational purposes only and should not be considered as legal advice and does not establish an attorney-client relationship. Consulting with a qualified legal professional is recommended for specific legal concerns and requirements related to your business.


© 2023 Andrew Roy



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