Startups use Simple Agreements for Future Equity (SAFEs) to raise funds without the hassle of complicated valuations or equity sales. These agreements allow investors to invest money into the company in exchange for equity at a later time, usually at the time of a future financing round or exit event.
One of the most common types of SAFEs is valuation cap-only SAFEs, which set a maximum price at which the investor can convert their investment into equity. However, during a bear market, where valuations tend to decrease, valuation cap-only SAFEs can have some drawbacks. In this article, we’ll explore the advantages and disadvantages of valuation cap-only SAFEs during a bear market, and discuss the benefits of SAFEs that have not only a cap but also a discount.
Valuation Cap-Only SAFEs Explained
Valuation cap-only SAFEs are popular with startups because they are easy to understand and negotiate. With these agreements, investors can convert their investment into equity at a future date, but the maximum price at which they can convert their investment is limited by a cap. This means that if the company’s valuation is higher than the cap at the time of conversion, the investor can convert their investment into equity at a lower price and potentially receive a higher return on investment compared to the return investors in the priced equity financing get.
The Downside of Valuation Cap-Only SAFEs in a Bear Market
While valuation cap-only SAFEs can be a useful tool for startups, they can have some disadvantages during a bear market. One of the biggest drawbacks is that if the company’s valuation drops below the cap, the investor, who advanced money to the company, may not receive any upside on their investment compared to the return investors in the priced equity financing get. This can be frustrating for investors, especially if they have invested a significant amount of money into the company.
The Benefits of Discounts in SAFEs
One way to mitigate the downsides of valuation cap-only SAFEs during a bear market is to use SAFEs that have not only a cap but also a discount. Discounts allow investors to purchase equity at a lower price than the next round of funding, regardless of the company’s valuation. This means that even if the company’s valuation drops below the cap, the investor can still receive a return on their investment.
Example of a SAFE with a Discount
Let’s take a look at an example of a SAFE with a discount. Imagine a startup company that is offering a SAFE with a $2 million valuation cap and a 20% discount. An investor who invests $100,000 in the company would be able to convert their investment into equity at a maximum valuation of $2 million. However, if the company raises funds at a lower valuation, say $800,000, the investor would be able to convert their investment into equity at a 20% discount, which would be $640,000. This means that the investor would receive a higher percentage of equity for their investment than they would have if they invested at the higher valuation cap. If discount was not available to the investor, the SAFE would have converted at the same valuation as the round’s valuation ($800), meaning the investor did not receive any premium for advancing funds to the company.
Valuation cap-only SAFEs can be a useful tool for startups looking to raise funds quickly and easily, but they can have some downsides during a bear market when valuations tend to decrease. By adding a discount to the SAFE, investors are provided with added protection and potential for a higher return on investment, even if the company’s valuation drops. Additionally, the discount provides an added incentive for investors to invest in the company, as they are able to purchase equity at a lower price than other investors in the next round of funding.
Overall, it is important for startups to carefully consider their funding options and the potential risks and benefits of each. While valuation cap-only SAFEs may be a popular choice, they may not always be the best option from an investor’s perspective, especially during a bear market. By adding a discount to the SAFE, startups can attract investors while providing added protection for both parties.
In conclusion, SAFEs with both a valuation cap and a discount can be a powerful tool for startups looking to raise funds in any economic environment. By providing investors with added protection and potential for higher returns, startups can attract investment and grow their businesses with confidence. However, it is important for startups to carefully consider their funding options and consult with legal and financial professionals before making any investment decisions.
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