What Purpose Does “Valuation Discount” Serve in a Simple Agreement for Future Equity?

A Simple Agreement for Future Equity (“SAFE”) is a relatively new method to fund startups, created to help overcome the traditional hurdles that founders encounter when seeking funding.

When setting up a new venture, founders face the problem of establishing a realistic value for their company. Unlike mature companies, which are valued using the EBITDA formula (Earnings Before Interest, Taxes, Depreciation, and Amortization), the valuation of new startupsis estimated based ontraction, the founding team’s experience and skills, and how high the startup expects the profit margins to be.

Since the valuation of any new business enterprise is always somewhat speculative, investors tend to look for signposts that a new venture has a likelihood of success, and hold off investing until a significant number of investors (or at least one well-respected investor) has put money in. Waiting for a critical mass of investors can be nerve-wracking for founders.

Also, with traditional funding, there comes the inevitable process of negotiating with a mass of potential investors. This can be time-consuming and expensive for founders, who would like to bring in as much money as possible as soon as possible, but don’t want to dilute their own shares by offering too much equity in return.

A SAFE solves this problem. A SAFE is not a loan for a specific amount, which encumbers founders with interest payments, but rather an option to buy shares that automatically convert to stock upon the occurrence of a specified event. Founders determine the event that will trigger the issuance of shares, and it often occurs when the company completes equity financing for a set amount of aggregate proceeds.

A stock conversion may also be triggered with a “liquidity event” or “a dissolution event.” In case of a liquidity event, where the company is sold or admitted for trading on the stock exchange, the investor may choose between receiving cash back for the purchase amount or receiving ordinary shares of the company. If the company is dissolved (a “dissolution event”), the investor will receive cash back for the liquidation of startup assets (if any).

Founders prefer SAFEs over traditional equity funding because they are simpler and allow finance closings to be done with individual investors one at a time, rather than coordinating a single closing with multiple investors. There’s less time spent negotiating terms and less money spent on lawyers.

Valuation discounts serve as a lure to make a speculative investment more attractive to potential investors during the startup’s earliest phase. Since investing in a startup is a high-risk proposition, the typical investor is looking for a high return.  The discount helps ensure the high return by giving early funders a preferential investment position, allowing their investment dollars to go further in subsequent financing rounds than the same amount of dollars from investors who previously held off on investing. Discounts typically range from 10–30%.

For example, if a SAFE is issued with a 20% discount, then if the SAFE investor invested $40,000 in a startup, and the price per share comes out to be $10, he’ll get the share at a 20% discounted price, which is $8. This means he’ll get 5000 shares instead of 4000.

If you have questions about SAFE agreements, contact the highly skilled California business attorney Mohsen Parsa today.