Investment Options: SAFE vs. Equity

The VC Box

Dina Golfaridan

2021-06-21 12:55pm

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on:

The VC Box

Investment Options: SAFE vs. Equity

The VC Box

Dina Golfaridan

2021-06-21 12:55pm

Share on:

An investor looking to invest in a company may carry out its objective by way of various means, including but not limited to through a simple agreement for future equity ('SAFE'), keep it simple security ('KISS'), convertible note, or equity investment, amongst others. Given that each investment option has various benefits and drawbacks, the suitability of the investment option must be analyzed against the backdrop of the transaction, including but not limited to the stage in the economic cycle of the company, the size of the round, and the value of the investment. In this article, we compare two such investment options, namely investment through a SAFE and equity investment.



SAFE Investment


Fundraising in the early stages of a company, especially in the Middle East and North Africa region, tend to be accomplished through the issuance of SAFEs, rather than by way of issuing shares to new investors. A SAFE is an investment option for early-stage funding, whereby an investor provides funding to a company in exchange for the right to buy shares upon an equity financing round. The main negotiation points are the investment amount, valuation cap, and discount rate.


The key advantages of SAFE investments include:


  • Time and cost efficient: The terms are largely set and therefore less time and financial resources are spent on negotiation between the company and the investor. A company in its early stages will largely benefit from this as they can spend the raised financing on developing their business rather than on legal fees.
  • Flexibility: Valuing an early-stage company may be difficult and expensive. SAFEs allow the valuation of a company to be postponed to a later stage.
  • No interest: Startups prefer SAFEs because they are not debt and therefore do not accrue interest.
  • Future protections: An investor is able to take advantage of a most favored nation ('MFN' provision, which will ensure that if better terms are provided to a future investor, the SAFE holder inherits the same.
  • Early exit options: Another investor protection provision is that in case of a triggering event prior to conversion, the investor will receive an amount equal to a specified multiple of its investment.


The key disadvantages of SAFE investments include:


  • Uncertainty: As there is no maturity date, a SAFE holder will not be certain as to when its investment will turn into equity.
  • Enforceability of conversion provision: There may be questions regarding compliance with Sharia finance principles due to the element of uncertainty. However, this issue may be addressed by the parties including an exclusive dispute resolution provision calling for arbitration based on foreign law.


Equity Investment 


An investor may also invest in a company in exchange for share subscription in an equity financing round. In an equity round, a valuation of the target company is set, a price per share is determined, and the number of shares to be issued to each investor is calculated based on the investment amount, where the number of investor shares equals the investment amount divided by the price per share.

In an equity financing round, investors obtain a different class of shares, commonly referred to as preferred shares, with certain rights and privileges including but not limited to reserved matters, liquidation preference, anti-dilution protection, drag-along and tag-along rights. The most common transaction documents relevant to an equity investment round are a share subscription agreement and a shareholders' agreement. 

The key advantages of equity investments include:


  • Certainty: There is certainty with respect to the number of shares being issued to each subscribing investor based on the investment amount and valuation.
  • Enforceability: An equity investment is in full compliance with Sharia finance principles.


The key disadvantages of equity investments include:


  • Time consuming and costly: As compared to a SAFE investment, an equity investment is more costly and time consuming, as there is more time spent on negotiating the terms of the transaction. Additionally, once the shares are issued to a subscribing investor, this must be registered with the registration authority of the company by way of an amendment to the company's articles or memorandum of association. Given the comparatively lengthier process, an equity investment may be disfavored by early-stage companies due to a quick need for funding for the company to satisfy its operational expenses.


Conclusion

While raising financing through the issuance of SAFEs or issuance of shares are both viable options to consider for both companies and investors, early-stage companies in the region in their pre-seed and seed financing rounds tend to raise capital through SAFEs. Given the lower costs and higher efficiency of raising financing through issuing SAFEs, this option is more favored by companies with a short runway.