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What Is a SAFE Valuation Cap?
A SAFE or Simple Agreement 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 that 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.
What is a SAFE note?
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.
A SAFE note benefits startups because they (unlike convertible notes) are not loans and do not bear interest. 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.
Uncapped vs. Capped SAFE notes
The terms “capped” and “uncapped” refer to potential limits (or the lack thereof) on the valuation at which an investor’s SAFE note will convert to equity.
- Capped SAFE: This sets a maximum company valuation at which the SAFE will convert to equity. If the company’s valuation at the next funding round exceeds this cap, the SAFE holder will convert their investment into equity at this capped valuation, potentially obtaining a more significant equity stake than later investors in that round.
- Uncapped SAFE: This doesn’t set any maximum valuation for conversion. This means the investor is taking on more risk because they don’t have a guaranteed maximum price (or minimum percentage of equity) set for their investment. An uncapped SAFE can be more attractive to startups because it offers more flexibility and can be less dilutive to founders.
Why use an uncapped SAFE?
From a founder’s perspective, an uncapped SAFE can be advantageous because it does not set any valuation ceiling, potentially leading to less dilution when SAFE notes convert.
While an uncapped SAFE presents more risk due to the uncertainty about future valuations, investors might be willing to accept this risk if they are particularly bullish on the startup’s potential or if other investment terms are favourable.
However, it’s worth noting that while uncapped SAFEs might initially seem attractive to founders due to the potential for less dilution, sophisticated investors often prefer some protection on their investment, and capped SAFEs provide that protection. As a result, uncapped SAFEs can sometimes be harder to sell to prospective investors.
Why use a capped SAFE?
A capped SAFE (Simple Agreement for Future Equity) note is an instrument that allows startups to raise capital while providing investors with some protection regarding the future valuation of the company.
Opting for a capped SAFE over its uncapped counterpart can have several advantages for founders and investors.
- Investor Protection: A cap sets a maximum valuation to convert the SAFE into equity. This ensures that even if the company’s valuation skyrockets in the next funding round, the investor who took earlier risks will get to convert their SAFE at a potentially more favourable rate, giving them a more substantial equity stake relative to the money they invested.
- Clear Expectations: Caps provide clarity and set expectations about the investment terms. Both the startup and the investor clearly understand the valuation ceiling for the conversion, eliminating surprises down the line.
- Founder Dilution: While it might seem counterintuitive, having a cap can sometimes benefit founders. By offering a cap, founders can negotiate higher initial SAFE investment amounts since investors have more assurance about their potential return.
- Attractiveness to Sophisticated Investors: Many seasoned angel investors or venture capitalists prefer capped SAFEs because they provide more predictability and protection. If a startup is looking to attract such investors, offering a capped SAFE can be smart.
- Negotiation Leverage: The cap can be a point of negotiation between founders and investors. By being willing to discuss and adjust the cap, founders might gain leeway on other terms or conditions of the investment.
- Fairness: Early-stage investors often take the most significant risk by backing a young, unproven company. A capped SAFE acknowledges this risk by ensuring that these early backers are rewarded appropriately if the company sees substantial growth by the time of the next funding round.
- Simplified Future Rounds: When a company goes on to raise subsequent rounds of financing, having a capped SAFE can simplify discussions and negotiations. Prospective investors in these later rounds can see the terms that early investors received, which can help streamline their valuation and terms discussions.
- Moral Consideration: Some founders use capped SAFEs because they feel it’s morally right. They believe that early supporters and risk-takers should have assurances that their faith in the company will be rewarded.
While both capped and uncapped SAFEs have their places in the startup ecosystem, the former often strikes a balance between the interests of founders and early-stage investors.
Before deciding on the type of SAFE or any other financial instrument, startups should consult legal and financial professionals to understand the implications and benefits fully.
What is a SAFE valuation cap?
A valuation cap, often called a “cap,” is a key feature of a capped SAFE (Simple Agreement for Future Equity) note. To fully grasp how a capped SAFE relates to the valuation cap, it’s essential to understand the primary function of the valuation cap itself.
A valuation cap is a predetermined maximum company valuation at which an investor’s SAFE will convert into equity. Essentially, it sets an upper limit on the valuation to determine how many shares the SAFE holder will receive when the SAFE converts.
Why is a valuation cap in a SAFE agreement important?
- Equity Conversion Mechanism: When a subsequent equity financing round takes place (usually a priced round where the company’s valuation is explicitly set), the capped SAFE will convert into equity. The valuation cap determines how much equity the SAFE holder receives. If the company’s valuation during the equity financing round is above the valuation cap, then the SAFE will convert at the capped valuation, not the higher round valuation. This ensures that early investors get a larger percentage of equity for their initial investment.
- Investor Protection: The valuation cap is a protection mechanism for early investors. Without a cap, if the startup’s valuation significantly increased by the time of the next financing round, early SAFE holders might receive a relatively small amount of equity for their early, higher-risk investment. The cap ensures they get equity at a potentially more favourable rate.
- Dilution Clarity for Founders: The valuation cap also gives founders a clearer picture of potential dilution. Based on different valuation scenarios, they can anticipate how much of the company they’ll give away when SAFEs convert.
- Pricing Reference for Future Rounds: When raising subsequent financing rounds, having existing SAFEs with valuation caps can offer reference points for new investors. While the valuation cap doesn’t set the company’s actual worth, it provides a benchmark of what early investors were willing to accept.
- Negotiation Tool: The valuation cap is often a point of negotiation between investors and founders. An investor might be willing to accept a higher cap in exchange for other favourable terms or based on their confidence in the startup’s future potential.
In the context of a capped SAFE, the valuation cap is pivotal. It fundamentally shapes the relationship between the early investor and the company, influencing the rewards for early investment and the dynamics of future financing rounds.
Both founders and investors should be acutely aware of the implications of the valuation cap and how it interacts with the broader investment agreement.
Factors to consider when negotiating a SAFE valuation cap
A valuation cap is negotiable between the founder and the investor, bears both short-term and long-term implications, and must 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 be the case if the company’s early revenue generation shows a significant consumer increase over time.
- The industry impacts the valuation cap. Software companies have larger valuation caps if they have the potential to expand in the market.
- The chances of a higher valuation cap 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 before negotiating the valuation cap.
- The track record concerning the founder’s prior financial return is a crucial factor in determining 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 to negotiate successfully.
You are likely to be manipulated if you do not have multiple alternatives. Therefore, securing numerous investors is critical to successfully negotiating a valuation cap.
After securing alternatives, you need to deconstruct the evaluation of your investors, provided it is not favourable for the company’s future, which may include identifying concerns that may cause valuation subtraction. You also will have to accept that negotiating is relatively subjective.
The third negotiating tool is the terms in the SAFE note that could be traded for an increment in valuation, which can be employed for mutual benefit.
Finally, you need to clarify the lead investor’s investment amount to outline equity warrants. In this way, the lead investor is given their target equity.
Conclusion
A SAFE note provides startup entrepreneurs to secure investments without the hassle of interest payments. It gives the investor an equity exchange that may or may not be capped.
A valuation cap sets the maxim limit for the investor to exchange their SAFE note. The devaluation cap on SAFE notes primarily incentivizes investors to supply investment in budding startups.
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., before negotiating the devaluation cap.