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Financing for startups: Why is the topic of SAFE Notes also relevant in Germany?
In the Anglo-American legal area, the SAFE ("Simple agreement for future equity" or "SAFE Note") is very common for financing start-ups. It is therefore not surprising that this financing instrument is also used in Germany from time to time in the context of financing rounds or as part of the Employee participation Appears. Especially if US investors are involved. We explain here what this agreement is and what the advantages and disadvantages of this form of financing are.
Differentiation from Convertible Loans & Basics of SAFE
Convertible Loans vs. SAFE
One SAFE (Simple Agreement for future equity) is a contract between a company, usually a startup, and its investors. It is similar to the very common in Germany Convertible loans similar, but
- without one Interest and
- No repayment of the loan amount when a defined due date is reached.
Due to these disadvantageous points of the convertible loan (for startups), the SAFE was developed by the American startup accelerator Y Combinator and is mainly used in seed financing.
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More information on convertible loans
How the SAFE works
The investor provides capital to the startup and in return receives the right to convert this capital into equity in the future (e.g. by cash capital increase or conversion of the capital reserve). However, as in the convertible loan, certain criteria and conditions are already defined today, such as:
- Valuation cap (Valuation Cap)
- Valuation floor (floor)
- Feedback estimates (discount)
In addition, sometimes other rights are provided. E.g.
- Co-signing rights (pro-rata rights) that allow the investor (no obligation) to participate in later rounds in order to keep his share of the company constant.
- Most-favoured-nation clause ("Most favored nation" or "MFN" for short). If the company gives better terms to other investors in a later funding round (e.g., lower valuations, higher discounts, better liquidation preferences), the original investors will get the right to adopt those more advantageous terms as well. This clause therefore protects investors, if agreed.
The conversion of debt capital into equity or payment of a sum of money similar to virtual option models takes place in a so-called Triggering Event , such as a subsequent financing round, an initial public offering (IPO) or an acquisition of the company.
Example - postponement of valuation to the future
An investor invests in t 0EUR 500,000 in a start-up via a SAFE agreement. At this point, it is not yet clear how many shares it will receive. In the next round of financing t 1 the startup is valued at EUR 2,000,000 (valuation) and the investor's investment is converted, in this case 25% (EUR 500 thousand/ EUR 2,000 thousand).
Of course, a different result would also be possible if in t 0 a predetermined price or discount for the shares would have been agreed.
As always in life, there are advantages and disadvantages to the SAFE. We present these separately for the company (startup) and for the investors.
2. Advantages and disadvantages of SAFE for the company
2.1 Benefits of the SAFE for the Company
No pressure to rate
The startup's company valuation is postponed to the future. Valuation is often difficult, if not impossible, especially in the early stages of a company. Often, there are no significant sales yet and EBIT is deeply negative due to the investment phase. Due to the postponement to a triggering event, the valuation only takes place when there is a market valuation by outside investors.
Simplification of the investment process through standardized contracts
The use of standardized contract terms simplifies the process and usually reduces legal costs. However, it should be borne in mind that these contracts must comply with German law and, if necessary, a notarial certification must also be carried out. This applies in particular if the SAFE recipient is to become a shareholder in the end and receive real shares within the framework of the applicable company law (see e.g. §15 para. 3 GmbHG ). A prior examination by a lawyer is therefore advisable.
Flexibility for business owners & founders
Founders can, similar to the Convertible loans , respond flexibly to different financing needs. In contrast to a loan, however, the pressure of interest payments or repayment obligations is reduced.
SAFE may be treated as equity
A SAFE also counts (as the Convertible loans ) to the mezzanine forms of financing, is therefore a hybrid between equity and debt capital.
In order to qualify as equity-like, the SAFE must not receive a repayment obligation (otherwise accounting as liabilities) and must also contain a qualified subordination in the event of insolvency. In other words, the agreements to be treated as an equity investor as a SAFE holder in the event of (imminent) insolvency or over-indebtedness.
2.2 Disadvantages of the SAFE for the company
Lack of predictability
The actual terms of the conversion depend on the next round of financing, as the SAFE price is usually calculated on the basis of a discount or cap. Without a clear idea of the future equity requirements, the future valuation of the company could be unexpectedly disadvantageous.
Uncertain shareholding structure (dilution)
Until the triggering event, e.g. a financing round, it is uncertain what share SAFE shareholders will receive and thus how the dilution of the shares of the existing shareholders will turn out. Especially in cases where the company valuation is significantly below the cap, this can lead to undesirable results.
Example - How the SAFE works & dilution
Business angel woman early invests 100,000 EUR with a SAFE and secures in t 0a cap of 2,000,000 EUR company valuation on NEW Internet Stars GmbH. Twelve months later, it turns out that the company is worth 20,000,000 EUR. VC Rakete invests 6,000,000 via capital increase, in which Ms. Früh also participates, and receives 30% of the shares in return:
Step 1: Convert the SAFE
The SAFE investor Früh converts your investment based on the Valuation Cap of 2,000,000 EUR .
Shares of the SAFE investor:
- SAFE is converted to a valuation of 2,000,000 EUR: Share of SAFE investor = 100,000 / 2,000,000 = 5 %
- After conversion, it lasts 5 %of the shares.
Interim status after SAFE conversion: The remaining 95 %belong to the founders.
Step 2: New round of financing
The new investor wants to 30 %of the shares after the financing round.
Shares of the new investors: In order to receive 30% of the shares, the share of the existing shareholders (founder and SAFE investor) will be diluted accordingly. The new investor pays on the basis of a valuation of 20.000.000 EUR (pre-money) .
- After the round, the shares of the existing shareholders together represent 70 %of the shares.
- The distribution of these 70 %remains proportional:
- Founder: 95% of 70% = 66,5 %
- SAFE Investor: 5% of 70% = 3,5 %
Capital of the new investor: The new investor pays:
Investment = (30 % share / 70 % (existing value)) × 20,000,000 = 8,571,429 EUR (post money valuation)
Final distribution of shares
After the financing round, the following structure will result:
| Participant | Share (%) | Ordinary contribution (EUR) | Post-Money Valuation (EUR) |
|---|---|---|---|
| Founder | 66,50 % | 16.625 EUR | 13.300.000 EUR |
| SAFE Investor | 3,50 % | EUR875 | 700.000 EUR |
| New investor | 30,00 % | 7.500 EUR | 6.000.000 EUR |
| Total | 100 % | 25.000 EUR | 20.000.000 EUR |
Cognition
- The founders start with 100 %and only hold after the round 66,5 %of the shares.
- The SAFE investor receives 3,5 %and benefits from the low valuation cap, as he receives significantly more shares than the valuation of EUR 20,000,000 would actually allow.
- The new investor pays 8.571.429 EUR (post money rating) to 30 %of the shares.
The founders experience a double dilution: due to the SAFE conversion and the new investors.
Possible conflicts with future investors
The example above shows the potential for conflict that can arise if later investors see the conditions of the early-stage investors as too advantageous and demand renegotiations accordingly, which can lead to further dilution.
Legal and tax risks
As mentioned, the SAFE has developed from the Anglo-American legal system and may therefore have to be adapted to German law. Due to the lack of experience with this instrument, tax risks can also arise if, for example, valuation caps granted to employees are considered a non-cash benefit.
3. Advantages and disadvantages of SAFE for investors
3.1 Benefits of the SAFE for investors
Flexibility
SAFEs are flexible and allow investors to invest in a company early on without the need for an immediate valuation. As an investor, I can therefore be more sure that I am paying a market value than through an arbitrary pre-money valuation by the founders, as is often the case in the Convertible loans happens if there is no qualifying financing round.
Rabatte & Discounts & Caps
Many SAFEs include discounts on future funding rounds. This means that investors can receive shares at a reduced price early on or pay only an upper limit (valuation cap). For this reason, the SAFE Note, as with Convertible loans especially popular for early-stage investments.
Granting of advantages
As described above, an investor can acquire certain advantage rights such as " Pro-rata " or " Most Favored Nation (MFN) ".
PRACTICAL NOTE:
Advantage rights are usually not automatic, but must be explicitly negotiated by the investor. To do this, it is necessary to be aware of this type of rights and to explicitly refer to them during contract negotiations.
The fact that other investors have not negotiated them should not be used as an argument. You should therefore negotiate the MFN option with your contract in particular in order to be put on an equal footing with future investors.
3.2 Disadvantages of the SAFE for investors
No co-determination rights
Since SAFE is NOT a corporate law construct, SAFE subscribers have no shareholder rights. In other words, no voting rights or control over corporate decisions, such as co-determination over the composition of the management board. The possibility of intervening in business decisions is therefore non-existent.
PRACTICAL NOTE:
It is questionable whether the investor has rights to information. To be on the safe side, the SAFE should therefore explicitly describe that you are informed about important business transactions, e.g. business figures, changes of organs or updates on material financing transactions.
Risk of conversion
SAFEs are only converted into equity if a defined trigger event occurs (e.g. a financing round or an exit). If none of these conditions occur, the investor remains in an uncertain position. To make matters worse, there are no clear timelines for a conversion (as is the case with convertible loans, for example), which makes planning difficult for investors. In the worst case, there is never a change.
PRACTICAL NOTE:
The lack of conversion is one of the main risks for the investor, so the German GmbH will usually be subject to notary obligations. In addition, one should discuss whether the distribution should also lead to inflows for the investor, which is not the rule, or whether a distribution ban applies to all shares until the SAFE is converted.
Otherwise, in the absence of a conversion, the existing shareholders could participate, but not the SAFE owners.
Unclear assessment
The exact share of the investor will only be determined at a later financing round or another trigger event. Until then, it is unclear how large the share will actually be. For example, if the company raises at a high valuation (and no valuation cap or discounts apply), the SAFE investor may end up receiving a much smaller share than expected.
4. Conclusion
Although the convertible loan is still the predominant investment vehicle for early-stage investors, there is still participation via the SAFE (Simple Agreement for future equiy) from time to time. If you want to subscribe to such an investor as an investor, you should deal with the matter carefully. In particular, the practical advice mentioned here is highly relevant.
No problem. We are happy to help with the examination or negotiation.
Duration: 30 min.
