When a SAFE is no longer SAFE

The GFC and the present-day period are both marked by a decline in public trust in institutions, and private markets, with less exit value and fewer public listings. However, corporate M&A and investment activity remained resilient, thanks to factors such as high levels of capital on corporate balance sheets and an evolving venture ecosystem. In 2022, despite declining economic factors, corporates remained resilient, with a record proportion of US VC deals including CVC investors. Valuation declines have created opportunities for capable corporate acquirers and investors to make bold, strategic plays that were previously out of reach, and the current economic period may be competitively advantageous for corporations with more favourable capital structures.

But there are some cold hard realities founders and VCs need to face:

SAFEs (Simple Agreements for Future Equity) are no longer considered as safe during market volatility.

Here are five main reasons why:

1. Lack of clarity on valuation: A SAFE is designed to provide a framework for future equity investment, but it does not establish a valuation for the company at the time of the investment. This lack of clarity can be particularly challenging during market volatility, where the company's value may fluctuate significantly.
2. No investor protections: Unlike traditional equity investments, a SAFE does not provide investors with any governance or control rights. This means that investors may not have a say in how the company is run, and they may not be able to protect their investment if things go wrong.
3. Uncertainty around conversion: A SAFE is intended to convert into equity at a future point in time, but the terms of the conversion are not always clear. This lack of certainty can create ambiguity around how much equity investors will receive, and when they will receive it.
4. Limited upside potential: A SAFE typically offers investors a discount on future equity, but this discount may not be sufficient to compensate for the risks associated with investing in an early-stage startup. As a result, investors may not be able to capture the full upside potential of the investment.
5. No dividends or interest: A SAFE does not typically offer investors any dividends or interest payments. This means that investors may not receive any return on their investment until the company either goes public or is acquired.

Given these challenges, a VC may consider structuring an investment in a startup differently during market volatility.

For example, they could consider a convertible note, which offers investors more clarity around the valuation and conversion terms, as well as governance and control rights.

Alternatively, they could explore a traditional equity investment, which offers investors a greater degree of upside potential and dividend payments.

Ultimately, the choice of investment structure will depend on the specific circumstances of the company and the preferences of the investors involved.

Why Founders prefer convertible notes during volatility

Founders may also prefer convertible notes in times of market volatility because they offer flexibility and lower upfront costs compared to traditional equity financing.

During times of uncertainty, it may be difficult for founders to accurately value their company, which can make equity financing less attractive. Convertible notes provide a way for founders to raise capital without having to agree on a valuation upfront, as the conversion price is determined when the note converts into equity at a later date.

Additionally, convertible notes typically have a lower upfront cost compared to equity financing, as they do not require a full valuation and do not involve the issuance of equity shares. This can be particularly beneficial for startups that may not have a clear path to profitability or strong revenue streams in the short term.

Finally, convertible notes can offer flexibility in terms of repayment, as they may allow for the conversion of the note into equity, repayment in cash, or a combination of both. This can provide founders with more options for managing their cash flow during periods of market volatility.

Overall, convertible notes can be an attractive financing option for founders during times of market volatility due to their flexibility, lower upfront costs, and ability to defer valuation until a later date.

In today’s world, investors are increasingly looking for more than just financial returns. They want to invest in companies that are making a positive impact on society, and they want to work with firms that share their values. By focusing on team and purpose, venture capital firms can differentiate themselves from the competition and attract the best investors and entrepreneurs.

For only together can we accelerate impact.

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About the Author

Leesa Souldore ?is the General Partner of R3i Capital,?a global sustainable development venture capital fund ?investing in climate change adaptation and the transition to value-based healthcare. Reach out if you would like to learn more about our mission in the?R3i Future Fund.

What’s in our name?

R3i stands for returns, resilience and reliability — three characteristics that are often used to describe or evaluate investments, businesses, or other assets.

Together, these three characteristics can be important factors to consider when evaluating the potential risks and rewards of an investment or asset.

3 i’s — “Intelligence, Innovation, Insight” are the three characteristics that are often used to describe a venture firm’s edge. R3i synthesises these into its collective and inclusive “impact”.

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