Why Should Founders Determine the Valuation Cap for SAFE Notes?

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Written By Sarath C P

A valuation cap, decided by startup business owners, is the highest value used to determine the share price at which an investor’s funds turn to equity.

While some compelling companies can float with uncapped SAFE notes, the importance of a valuation cap in safe notes comes into play to negotiate with the investors with the safe notes in a seed funding round. Using the valuation cap, startups can compensate seed-stage investors for taking on additional risk by investing in a startup without a debt instrument.

The value limit on your SAFE notes establishes the maximum price at which it may be converted into equity. Investors will be entitled to equity valued at the lesser of the pre-money valuation or valuation cap in future fundraising.

What is a SAFE note valuation cap?

What is a SAFE note valuation cap?

Y Combinator, a Silicon Valley accelerator, developed Simple Agreement for Future Equity (SAFE) notes in 2013 to let entrepreneurs organize early funding without interest rates and maturity dates.

SAFE is convertible security that simplifies and standardizes the process of acquiring initial financing for startups. SAFE notes enable entrepreneurs to get venture capital (VC) funding immediately while deferring the documentation, expenses, and time necessary for an equity round at a future stage.

With SAFE notes, investors contribute to a firm in return for a share in a future equity round. A typical 15 per cent equity is often equivalent to a standard SAFE investment.

The valuation cap is the highest price established by a SAFE note at which an investment could be converted into shares. All kinds of convertible securities require a valuation cap.

Since the valuation cap sets the value of an investor’s shares, it is imperative to negotiate it. Investors prefer valuation caps to be low. The amount of stake the investor will receive will decrease with the higher valuation cap.

How does a SAFE note work?

Entrepreneurs often employ SAFE notes before raising their seed financing. A SAFE is designed to help startup business owners conclude a transaction immediately, unlike typical venture capital rounds, which call for entrepreneurs to recruit lead investors or even pull many VCs into the same round.

The typical SAFE note is five pages long and not very complicated. The contract is negotiated based on an investor’s risk with a SAFE.

The only thing entrepreneurs typically need to negotiate with the investors with the safe notes is the valuation cap. Risks can be reduced by factors like an established product or incorporation.

How does the valuation cap work in SAFE notes?

How does the valuation cap work in SAFE notes?

When a subsequent fundraising round occurs, investors’ stake in a SAFE note is turned into shares. SAFE notes are designed to convert to stock upon certain trigger events, most often the subsequent round of fundraising or sale of the business.

It often features conditions that are beneficial to investors, including a discount and a valuation cap. The instrument becomes stock at the current rate if neither a valuation cap nor a markdown is provided.

SAFE investors get discounted future shares as compensation for their early faith in the potential of your business. They can negotiate a valuation cap.

Some entrepreneurs assign a variable valuation cap to each SAFE issuance, depending on the value the investor brings to the table. Many adhere to a single valuation limit for every round of SAFEs to simplify computations.

How does a SAFE note valuation cap work? 

The SAFE price determines how many shares owners get upon conversion. Investors may go with a prime rate if the valuation cap rate and the discounted rate result in different costs per share.

By dividing the valuation cap by the firm’s market capitalization, the SAFE price is determined. The overall worth of a firm is the combined value of all its shareholdings of capital stock and common stock. It is known as company capitalization.

Valuation cap/company capitalization = SAFE price

When SAFE notes are introduced to the market, the market as a whole is impacted differently than it would be with convertible notes. SAFE notes do not include interest rates, maturity, or presumed exit dates.

Some individuals may want to make up for losing out on these aspects by earning money. Hence, owners might need a lower conversion ceiling or a more significant conversion discount.

Regarding SAFE notes, negotiating is an essential part of the process. Investors consider seeking a lower cap or more significant discount since the SAFE note’s structure is less adjustable than a convertible note.

Why should founders determine the valuation cap for SAFE notes?

Why should founders determine the valuation cap for SAFE notes?

There are several benefits for business owners to utilizing SAFE notes and determining a valuation cap based on the investment value provided by investors. Here is a list: 

  • Less complexity: SAFE notes are often fewer than five pages long and easy to grasp, one of their main advantages. This is partly because, in contrast to a convertible note, there aren’t expiration dates or interest charges to be concerned about.
  • Simple accounting: There are no problematic tax repercussions since SAFE notes are part of a company’s capitalization table.
  • Less negotiation required: Because SAFEs are so straightforward, there are fewer things to agree upon, resulting in a clear and short discussion of all pertinent issues. The valuation cap and the discount rate are the only serious issues that must be discussed and negotiated.
  • Owners have more control: Owners have a lot more autonomy and choice as no payback commitments and maturity dates are hanging over their heads.
  • Several benefits for investors: Investors are motivated to use SAFE notes since they may be changed into preferred stock, sometimes at a reduced price. Investors could get advantages that are superior to their initial investment.

Are there any challenges to SAFE notes?

Despite its advantages as a flexible mode of investment for owners, there are several challenges that investors must remain aware about:

  • Risk: Investors have no assurance that a SAFE note will ever convert into stock since it relies on how the firm develops.
  • Lack of continuous revenue: Since SAFE notes are not debt instruments, investors don’t get any interest or other payments. Investors, thus, sometimes make less money over time.
  • No dividends: Most of the time, SAFEs don’t pay dividends to investors. Instead, equity is the only return on an investor’s investment in a SAFE.
  • Business incorporation is required: Only incorporated companies can utilize SAFE notes during negotiations. Like other stock options, this investment is listed in a C corporation’s capitalization table. An LLC business must restructure, incorporate, get legal assistance, and pay expenses if it wants to issue SAFE notes.
  • Require fail valuation: The potential need for a fair valuation, commonly known as a 409a, to estimate your company stock’s fair market value is another possible cost related to issuing SAFE notes.

Even though SAFE notes can be helpful when looking for initial investment, it might be challenging to convert them into share ownership and include them in your 409A valuations.

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