Thursday, 11 June 2015

Why SAFEs are increasingly being entered into the UK…

Increasingly, founders of tech start-ups in the US are issuing simple agreements for future equity (“SAFEs”) as an interim equity fundraising instrument. In turn, we are starting to see these instruments creeping into the UK start-up scene. So what are these SAFEs, and why would you use one?

All too often, I am witness to painful valuation discussions at pre-Series A stages which distract founders and can taint their relationship with the early investors. In the right circumstances, SAFEs provide a useful alternative.

SAFEs are simple equity subscription commitments which are used instead of conventional seed equity issues or convertible loan notes. They are a helpful tool in that, unlike convertible loan notes (which commonly carry an interest rate and a redemption mechanism for the period that the notes remain unconverted), they are contracts for pure equity. The key benefit over a share issue though, is that the valuation need not be fixed at the time the SAFE is put in place; rather it is commuted into the next funding round when the equity committed by the SAFE is actually issued, potentially with a discount or cap on valuation attached. SAFEs contain basic reps and warranties, and provide for the SAFE holder to get customary investor protection in proportion to that offered to future investors. As a result, SAFEs tend to be much quicker to negotiate and close than the alternatives.

In the UK, while we have seen a number of SAFE proposals in recent months, they have not quite entered the mainstream. We do have something similar, in that the practice has developed for SEIS/EIS investors who need to provide ad hoc financing to companies to enter into “advance subscription” commitments with companies. These advance subscriptions developed as a practice owing to the restrictions in the SEIS/EIS legislation on use of convertible loans. So effectively, the advance subscriptions are irrevocable commitments for future equity. They are not always simple (compared to a SAFE agreement which can be just 5-6 pages long) but they operate in a similar way.

So, as the funding environment remains strong in the UK, I predict that we will see more and more of the hottest early stage companies deferring difficult valuation discussions during seed stages, and instead doing SAFE financings, which can be structured in such a way as to take advantages of the sought after SEIS and EIS tax reliefs.

Investors who may be tempted to agree to a SAFE will need to get comfortable that the Company is in good shape, and that matters like founder vesting/ leaver provisions and other basic protections have been provided for by the Company. While the funding climate is strong at present, a five page SAFE will rarely by itself give enough comfort to first time investors. Either (i) the SAFE needs to be put in place alongside a customary governance regime containing typical investor protections; or (ii) SAFEs will be used more as emergency or bridge financing where a conventional round has already taken place.

However, as long as the funding climate remains strong, we will surely be seeing more of these.