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The Founder's Dilemma: Priced Equity Rounds vs SAFEs

By
Quentin Wallace
May 28, 2022

My last blog was a high level look at the journey forward in this series. Today, we get stuck right into one of the big issues for founders: price rounds versus SAFEs. But before we do that, let’s have a quick look at what’s involved in the first phase of fundraising: building the round.

Phase 1: Building the round

If you’re reading this document, you might have already started this process. That said, there is more to fundraising than just having coffee or Zoom calls with potential investors.

Key features of this phase are:

  • Talking with existing investors
  • Deciding on the round type
  • Meeting with new investors
  • Commercial due diligence
  • Getting a term sheet from a lead investor
  • Getting commitments from other investors

Priced equity round versus SAFEs

Deciding on whether to do a priced round or a SAFE is one of the most common questions we get from founders. It’s also a very important question to solve at the start of your fundraising journey. While some elements will be shared between the two, you will probably use different strategies for each method. There is also a potentially significant time difference between the priced rounds and SAFEs. As a basic rule of thumb, I think a priced round takes about 3-6 months to complete (from first conversations to money in the bank). In contrast, most SAFE rounds can be done quite quickly (eg 1-3 months), but this depends on how many SAFEs you need to get to your fundraising total.

In the end, neither method is better for early stage fundraising, there’s only what works best for you.

Priced rounds

A priced equity round is where the share price paid by investors is set at the time the round is completed. To do this, the startup has to be valued. For example, the startup might raise $500K based on a pre-money valuation of $5M. After the fundraising is completed, the startup will have a $5.5M post-money valuation because $500K of capital value (in cash) has been added.

While this is a simplified way of looking at things, it’s easier than talking about share prices. Ultimately, the price per share is what investors pay (ie the pre-money valuation divided by all the shares and options on issue), but it will vary wildly between startups based on the actual number of shares on issue. So, most investors and founders refer to pre-money and post-money valuations when they talk about fundraising rounds. It’s also a key concept to understand for SAFEs (see below).

The process for completing a priced round will involve the following core activities:

  • getting a term sheet for a lead investor or agreeing terms with a core group of investors;
  • completing legal due diligence;
  • creating, negotiating or amending (as applicable) transaction and company documents; and
  • closing the round (eg signing documents, receiving funds and issuing shares).

While we’ll talk more about each of these activities in later blogs, it’s important that we quickly go through the key transaction documents in a priced round now. Without this understanding, it’s hard to grasp the core difference between a priced round and SAFE.

Transaction documents

As priced rounds involve investors purchasing shares and becoming shareholders in the company, the following documents need to be created, negotiated or amended as part of the round:

Term sheet

A term sheet is a 1 - 3 page document setting out what the lead investor(s) and the startup agree are the key terms for the priced round. eg total amount raised, valuation, share rights, key rights in core transaction documents (see below). Term sheets are usually not binding, except for things like confidentiality, so they are usually more a social commitment and a guide for lawyers to start drafting documents. That said, culturally, it’s generally a big deal for parties to deviate from the term sheet. I have seen term sheets for a SAFE round, but I think it’s totally unnecessary and you’d be better off just sending a SAFE with the terms included.

Subscription Agreement

This is an agreement that governs the issue and purchase of new shares in the company. It also includes a number of warranties (ie statement of fact) about the company and the shares. For the sale of existing shares (eg in a secondary sale) this would be called a Share Sale Agreement.

Company Constitution

This is the primary set of rules that govern how the company is run.

Shareholders’ Deed

This is an agreement between the company and shareholders that determines how the company will be governed and what rights shareholders will or won’t have. The Shareholders’ Deed sits above the Constitution and provides more detailed rules or varies the Constitution.

Board and shareholder resolutions

Completing a price round also involves drafting and executing several board and shareholder resolutions that are required under the company’s existing corporate documents. These documents are not as long as the Subscription Agreement, Constitution and Shareholders’ Deed, but they are necessary and still take time for lawyers to draft.

For founders and investors, the most important documents in this process will be the Subscription Agreement and Shareholders’ Deed. These documents contain the core mechanics of the fundraise process and how the company will be run in the long term. Along with any legal due diligence investors might do, it’s the negotiation and amendment of these two documents that generally requires the most time during a priced equity round. There are strategies to reduce this time (eg a term sheet), but it’s a process that largely relies on people, so it’s hard to compress.

Priced equity rounds in Australia

While the core terms contained in the Subscription Agreement and Shareholders’ Deed are becoming more standardised in Australia, there is still quite a lot of variation. Some of this will depend on the stage of the investment (eg Seed versus Series B+), some of this will depend on the particular lead investor. VC funds are run by people, and just in the rest of life, people may anchor on items due to past experiences. Some “non-negotiable” items for VC funds, might be “nice to haves” for other VC funds. These human factors can prolong negotiations, so it’s useful to identify the “must haves” from the “nice to haves” early on so things can progress relatively smoothly. This can be done through open communication and choosing investors that have a collaborative mindset. Good luck with that…

Pros and cons of priced rounds

Pros

  • The key thing that priced rounds provide is certainty. The company is valued at the time of investment, the share price is set and the cap table is locked. There are no nasty dilution surprises (eg with stacked SAFEs) and founders know exactly where they stand.
  • Another benefit of a priced round is that investor legal due diligence can unearth early issues (eg deficient employment contracts). These issues are usually fixed at the time of the round and so don’t cascade into larger issues later on.
  • Priced rounds allow investors to receive the ESIC tax benefits (in early rounds). This might not mean much to founders, but I have been anecdotally told that some investors are likely to increase their investment if the investment qualifies as an ESIC.

Cons

  • Priced rounds usually require more time to build and complete than SAFEs. They can often be a distraction for founders as they spend lots of time focused on fundraising and closing the round rather than building the company. This is usually more pronounced in early rounds where there are fewer team members to share the load and less money to spend on external advisors (eg lawyers and accountants).
  • Priced rounds can also involve a lot of herding cats. It’s important to find a good lead investor for priced rounds. A good investor will have the experience and networks to run the investor side of the transaction while you run the company side.
  • If you are using a good lawyer (and we think you should), a priced round will cost more than raising through SAFEs. That said, there are several good legal firms that will offer early stage startups fixed priced fees for running a priced round.

SAFEs

A SAFE is a legal document called a Simple Agreement for Future Equity. The SAFE was developed by Y Combinator to create a way for startups to raise capital quickly and easily. It is similar to a convertible note, but does not accrue interest. Also, note that the name doesn’t have “note” in it. It’s a SAFE, not a SAFE note.
With a SAFE, the investors invest their money now on the promise that they will be issued shares at a later date (usually during a future priced round). The future priced round is used to determine the price of the shares that the investor will be issued. SAFEs usually have a valuation cap (eg $5M) and a discount (eg 20%) to determine the price and shares that the investor will be issued as part of the future priced round. This is done to benefit early investors who have invested their money in the startup to help it grow. If SAFE investors were issued shares at the same price as the future priced round, it would unfairly benefit later investors who have not risked their capital.

One key thing to remember with SAFE rounds is that they are not “rounds” in the true sense. SAFE rounds are usually a series of separate transactions where the company enters into a SAFE with each investor. While a SAFE round might involve investors being given the same valuation cap and discount, the terms for each investor might vary. This is a key difference to priced rounds where the terms for all investors are generally the same.

While you don’t have to sign all the SAFEs at the same time, I do often see founders wait until they hit a minimum fundraising threshold before completing the “round”. This is why people often talk about raising a “SAFE round” despite it not being technically correct.

Australian version of the SAFE

Unlike the YC SAFE in the United States (and some other jurisdictions), the Australian version of the SAFE is no longer a standard template. While it started out that way, the original version developed by AVCAL (now AIC) has morphed into a series of versions that often involve particular personalisations. This has created a fragmented document landscape that often catches out founders and investors and delays the time it takes to get SAFEs signed in Australia. I don’t say this to criticise, but just to point out that it can erode some of the time saving benefits that SAFEs have traditionally had over priced rounds.

Now, I’m not one to just complain without trying to fix things… Several of us with legal and / or investor experience have recently teamed up to produce a new Australian SAFE. It’s still a work in progress, but we hope to release it soon and that it can be adopted as the gold standard for Australia. Watch this space!

Pros and cons of SAFEs

Pros

  • SAFEs can be much faster to execute than a priced round. They only require one document (ie the SAFE) and you can sign each SAFE with investors as you go (ie you don’t have to wait for all investors to close).
  • SAFEs are much cheaper to execute. A lawyer drafting or reviewing one document is usually going to be cheaper than a lawyer drafting or reviewing three (or often more) documents in a priced round.
  • SAFEs can be used where company valuations are not easily determined. Examples of this are angel or pre-seed rounds where the startup is brand new or bridge rounds where the startup needs a quick top up to reach a milestone that can be used for raising the next round.

Cons

  • SAFEs create less certainty because they rely on an event happening in the future. In a way, you’re gambling on the future valuation of your company. Set the value cap too low and you get diluted more, set the value cap too high and investors won’t be interested. Having multiple layers of SAFEs can increase this uncertainty.
  • Price rounds (mostly) have one set of terms that all apply to all investors. With SAFEs, there is the potential for term fragmentation, especially with stacked SAFEs rounds. Things that increase this fragmentation include SAFEs with pre versus post money valuations, multiple value caps and side letters. When a priced round does occur, which is usually inevitable, the work to unravel everything can be complex and expensive. One word of warning, lawyers are usually not great at maths, so you may need a financial professional (eg accountant) to help you through this minefield. 
  • As mentioned earlier, SAFEs are not eligible for the ESIC tax concessions. This (I’m told) may reduce some early investor’s cheque size, meaning you raise less or have to get more investors to hit your raise target.

So what’s better?

As I previously said, there is no right or wrong method to raise capital when using SAFEs or priced rounds. It’s a horses for courses approach.

That said, I can tell you what I often see. This is not an endorsement of the best way to raise capital, just an observation of what founders often choose to do in early rounds.

In the last few years, a lot of founders have chosen to raise their first (or second) round of external capital using SAFEs. This is usually because the company is hard to value at that stage or they don’t have enough traction yet to get a suitable valuation. After a while, when they’ve got more metrics to show investors, they complete priced round 

In many ways, this is a sensible approach. Early startups (especially pre-revenue) are hard to value properly and founders are very cautious of overly diluting their ownership. But even more important, are the timing aspects. Early startups are constantly on the clock and the quicker you can get capital into your company and start using it to hire, build product and test the market, the greater your chances of long term success (in my opinion). Startups that spin their wheels for too long are the bane of investors and often a red flag.

Next week

In next week’s blog, we’ll look at how to find new investors, how to talk to existing investors and what you might want to do before starting each of those conversations.

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