The Ultimate Guide to Negotiating a Valuation Cap on a SAFE Note
By Joanne Hue, Updated: 2023-02-21 (published on 2023-01-20)
SAFE or simple agreements for future equity is an alternative to convertible notes. Created in 2013, by Y combinator in the silicon valley accelerator program, SAFE allows growing businesses to organize and structure their seed business free from interest rates or maturity dates. Simply put, it is an agreement between an investor and the startup. It allows the investor to purchase stocks in the company during future equity rounds. A SAFE agreement is a simple and comparatively short document and consists of a negotiating valuation cap as a detail.
A SAFE note is a warrant that allows the investor to secure their option to purchase company shares in the future. It addresses the challenges of convertible notes and is a viable option for investors and founders. It is beneficial for startups because SAFE notes- unlike convertible notes- are not essentially loans and do not bear interests. An entrepreneur should be cautious while accepting SAFE notes as a currency because it guarantees the investor access to equity in their company.
A SAFE note may be capped or uncapped. A capped SAFE note has a ceiling on the valuation after the conversion of the note into equity. This provides the investors with an insight into the number of shareholdings in the future. either come with a valuation cap or no cap. Due to its clarity, SAFE note with capped valuation attracts investors more conveniently. The Valuation Cap is important to provide incentives to investors who are accepting additional risks by investing in a seed stage of a company. It is crucial to ensure financial security for a budding startup. The valuation price sets the range by specifying the maximum price for which an investor may convert the SAFE note into equity.
What is a valuation cap and why is it important?
Both Convertible notes and SAFE notes are subject to valuation cap. A valuation Cap is an upper limit for which the investor may convert their SAFE note into equity. It is important for startups that are seeking investors without the strain of interest payment. The early stages of the business tend to be prone to risk. A valuation Cap is an approach adopted to reward investors for investing early on in the business. Additionally, a valuation cap protects investors from getting smaller equity conversions that are disproportionate to their investment during the valuation rounds. If you are an investor you should insist upon valuation rounds because investments tend to get diluted when the company’s value increases.
The cap ensures that the investor does not get unfair equity proportions if the company’s value expands. In the event a company raises money above the negotiated cap, the investor has the authorization to invest at a price that is equal to the share cap. A valuation Cap is important to entrepreneurs and investors alike. In the case of entrepreneurs, subjecting SAFE notes to a valuation cap provide the investor with a reason to fund startups in the initial stages. This is especially valuable because collecting capital is the most crucial element that is needed for a business to take off. It is unlikely that lenders would gamble with their investments on businesses in the initial stages of establishment provided there was no assurance concerning proportionate advantage in the equity division. Therefore the valuation Cap on SAFE notes provides mutual benefits to entrepreneurs and investors alike.
Factors to consider when negotiating a valuation cap
A valuation cap is negotiable between the founder and the investor It bears both short-term and long-term implications and needs to be set based on the company’s growth potential. While negotiating a valuation cap, you need to consider the following factors:
- The company’s traction needs to be considered before establishing the valuation cap. The investors are likely to set higher valuation traction if the company shows that its product is fit for the market. Likewise, this may also be the case if the company’s early revenue generation, shows a significant increase in consumers over time.
- The valuation cap is also impacted by the industry. Software companies have larger valuation caps if they have the potential to expand in the market.
- The chances of a valuation cap being higher also increase with the leverage of the startup. Likewise, a low leverage status of the company might prompt the investor to set a low valuation cap or avoid investment.
- The overall fundraising market is also a factor to consider prior to negotiating the valuation cap.
- The track record concerning the founder’s prior financial return is a crucial factor in the determination of the devaluation cap.
- If the founders bear unapparelled experience in the field concerning the startup, then the valuation cap may be high.
Tips for successfully negotiating a valuation cap
While negotiating a valuation cap with an investor there are certain things you need to be mindful of in order to negotiate successfully. Provided you do not have multiple alternatives, you are likely to be manipulated. Therefore, a key to conducting successful negotiation of a valuation cap is securing multiple investors.
After, securing alternatives, you need to deconstruct the evaluation of your investors provided it is not favorable for the company’s future. This will require holding discourse against the notion that reduces the value of your company. This may include identifying concerns that may cause valuation subtraction. You also will have to accept that the process of negotiating is fairly subjective.
The third negotiating tool is the terms in the SAFE note that could be traded for an increment in valuation. This can be employed for mutual benefit.
Finally, you need to clarify the investment amount of the lead investor in order to outline equity warrants. In this way, the lead investor is given their target equity.
A SAFE note provides startup entrepreneurs to secure investments without the hassle of interest payments. It provides the investor with an equity exchange that may or may not be capped. A valuation cap sets the maxim limit for which the investor may exchange their SAFE note. Primarily, the devaluation cap on SAFE notes incentivizes investors to supply investment in budding startups. As they are undertaking the risk of investing in a startup, they are rewarded by warrants in the equity division.
A devaluation cap is a negotiable aspect of the SAFE note. This negotiation is conducted between the founder and the investor. Investors need to account for the industry prospects, product performance, company traction, founder’s history etc prior to negotiating the devaluation cap.
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