Should I raise using a SAFE?

Background

When Profitual works with pre-seed founders, we always end up talking about their fundraising goals. While the amount that needs to be raised is the most pressing issue when creating their financial forecast, the conversation usually switches to what instrument they should use to raise the round (i.e., what should they issue investors in exchange for their capital). 

Let’s dig into our options!

Common Structures: Equity & Debt

Equity: Common & Preferred Shares

If a startup goes the equity route, it will be issuing either common or preferred shares. In this case, you need to put a valuation on your startup and issue shares at a corresponding price. The difference between common and preferred is just as the name indicates, where preferred shares have certain benefits that common stock does not (a preference). The preference can vary widely but often includes anti-dilution provisions, liquidation preferences, dividends, etc. 

At the pre-seed stage, I frequently tell founders to start negotiations on common shares, and only offer preferred shares if they must. Preferred shares are used a lot in financings, especially at later successive stages where the round being raised is over $1M - so they’re nothing to shy away from! If you’re going to offer those investors ‘perks,’ it’s important to know how their preferences work. 

Debt: Convertible Debentures & SAFE Agreements 

Convertible Debentures and SAFE (Simple Agreement for Future Equity) agreements are often used in two scenarios: 

1) A pre-seed company raising their first financing round, and

2) A bridge round, raised to provide the company with operating runway ahead of a future larger round of financing.

Both convertible debt and a SAFE are investments for FUTURE equity in a startup. So, investors don’t receive shares and won’t sit on the cap table right away, but their cash will convert into shares later. I like to think of them as debt (they’re a liability on the Balance Sheet) that eventually finds its way to shareholders' equity once converted. What is the most common event to trigger this conversion? The company raises its next priced round of capital through common or preferred shares.

These instruments work well in a pre-seed round as they allow the founder to close a round without having to define how much the company is worth (place a valuation), the legal fees are usually lower as it’s a very simple agreement (like the name indicates), and the structure typically allows the founder to close the total round objective at different times over a few months, known as a rolling close.

Recent data from Carta states that 80% of the startups using their platform raised their pre-seed round with a SAFE. 

The benefits of using these instruments for a bridge round are similar in that they can be quick to execute, and the startup likely hasn’t seen enough progress to deserve a valuation increase on this round. Leveraging a convertible debenture or SAFE avoids a flat or down-round while they “bridge” to their next meaningful milestone, allowing them to raise with a valuation increase. 

What instrument should you use? 

There aren’t any “bad” choices when looking at the difference between equity and debt instruments. The decision usually comes down to the stage of the company and what’s realistic for each startup's fundraising situation/strategy. Sometimes you don’t have the runway to spend the 6-months it may take to raise a priced preferred share investment, so raising via quicker-to-close SAFE agreements wins out. Other times investors may state that they want to have the investment priced (equity) as they want to know what % of the startup they own today and not at some future date. Both scenarios are perfectly valid but result in different investment structures. Responsibility lies with the entrepreneur to understand the different structures and know which one works best for you. 

Atlantic Canadian Perspective

So, you’re a startup raising your pre-seed round, which (based on the date from Carta) almost assures you that you’re going to fall into that 80% of startups that use a SAFE to raise your investment, right? It really depends on whether you intend to raise from local Angel investors and if they have any interest in the tax credits that are offered by local governments. 

In New Brunswick, there is a tax credit called SBITC that allows investors to put money into a startup in exchange for shares and get a 50% tax credit. Essentially, if an angel puts in $50K they can expect to get $25K back when they file their personal tax returns (note there are various limits and other considerations here). This is an amazing program that has encouraged millions to be invested in local companies. Similar programs exist in NS, PEI, and NFLD.

The one downside is that the program doesn’t recognize SAFE’s (or convertible debentures) as acceptable investment vehicles and therefore aren’t SBITC eligible. So, the entrepreneur is left trying to pitch a SAFE to local investors that are (in theory) 50% riskier than any other startup that prices their round with equity. Note here that VCs in the region aren’t interested in the tax credit as they’re ineligible, so that isn’t a consideration for them. 

If a pre-seed startup in Atlantic Canada is going to target local angel investors, I would encourage them to be open on a structure that doesn’t just automatically pick a SAFE. Common stock investments are easier to understand than you think - and it may open you up to investors who really covet those tax credits. 

‍