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Uncategorised Nov 9, 2020 6 min read

SeedLegals launches UK version of YC SAFE for companies raising from US investors

Anthony
Anthony Rose

Have a US investor looking for a SAFE? You can now do that on SeedLegals.

Important news for any UK company looking to raise investment from US investors, SeedLegals’ hugely popular SeedFAST now has an option to match the deal terms expected by US investors looking for the deal terms in Y Combinator’s Post Money SAFE.

In this article I’ll explain what that actually means, give a quick background to convertible notes and SAFEs, explain the pros and cons of YC’s Post Money SAFE, and show you how to do your next US investment on SeedLegals with our UK version of a SAFE.

Quick background on SAFEs and SeedFASTs

In a traditional funding round the founders round up a bunch of investors, agree a valuation with them, and then the investors get shares in the company proportional to their investments and the agreed valuation. If you’ve managed to round up all the investors to fill out your round and managed to agree a valuation with them, brilliant.

But, what if e.g. you wanted to raise £500K, but you have an investor who wants to invest £50K now, and you could really do with that money now? It doesn’t make sense to do a funding round just to raise £50K, what if there was a way for the investor to give you the £50K now, and you promise to give them shares when you do your next funding round, based on the valuation you agree with the new investors in that round?

Historically the way to do that was using a Convertible Loan Note. But, as everyone who’s been following the UK government’s Future Fund initiative now knows, convertible notes aren’t compatible with the UK’s popular SEIS and EIS tax benefits for angel investors because they offer interest and a return on capital. As a result, convertible notes aren’t popular in early-stage UK funding rounds, where 80% of investment is SEIS/EIS. The solution that emerged a few years ago is known as an Advanced Subscription Agreement (“ASA”). At SeedLegals, we productised that and call it a SeedFAST. It’s hugely popular, with thousands having been created since we launched it two years ago.

Separately, in the US, Y Combinator were looking for a way to quickly and easily make multiple investments using standardised deal terms and without the insane US legal fees (SeedLegals isn’t in the US yet…). So they came up with a Simple Agreement for Future Equity (SAFE).

Their SAFE become hugely popular too, and now most pre-Seed Round investments in the US are done by SAFE.

The YC SAFE doesn’t work in the UK

If you’re a UK company raising money from a US investor, chances are high that they’ll ask for a SAFE. At first glance it’s tempting to just download a free SAFE template agreement from the YC web site, but you’ll quickly see that it won’t work, for two key reasons:

  1. It’s US law, it needs adaption to English law (quick, can you commit that a “Change of Control will qualify as a tax-free reorganization for U.S. federal income tax purposes”, where Change of Control is as per “Section 13(d) and 14(d) of the Securities Exchange Act of 1934”?).
  2. Its language, and the assumptions it makes about your future funding rounds, are designed for the US and just don’t make sense in a UK context. Common Stock, Safe Preferred Stock, Standard Preferred Stock… just names, but they won’t match things in your next round, and that could be problematic.

The good news is that since a SeedLegals SeedFAST is, at root, the same concept as a SAFE, when you have a US investor just get onto SeedLegals and create a SeedFAST for them, easy.

But wait… not so fast…

Introducing the Post Money SAFE

The first version of Y Combinator’s SAFE was similar in its key terms to a SeedFAST in that the SAFE converts as if it’s just another investment in the next round, at the same valuation as the other investments in that round (excluding any discount or valuation cap that you gave your SAFE investor).

But, two years ago Y Combinator proposed a new version, known as a Post Money SAFE – you can read all about it here.

In this new version, instead of the SAFE converting at the valuation of your next round (ignoring for now any discount or valuation cap that you may have offered to the investor), instead the SAFE converts at the next round valuation less the value of all SAFEs and other convertible instruments.

It’s easiest to understand this visually:

To see the difference, let’s assume you’re planning to raise a total of £500K in your next round, of which you’ll raise £200K in advance subscriptions which will convert in your round, and £300K in new cash investment.

On the left you can see that if you did those advanced subscriptions with SeedFASTs, the investments would all convert at a £2M valuation, and you and your existing shareholders would be diluted by

£500K / £2.5M = 20%

On the right, however, you can see that the Post Money SAFE converts at the valuation you agreed with the investors in your next round less the value of any existing advanced subscriptions, so in this example that would be at a £1.8M valuation.

This means you’re now diluting by

£200K / £2M = 10% for the SAFEs

£300K / £2.3M = 13% for the new investments

for a total of 23% dilution

So, what’s the idea behind Post Money SAFEs?

Y Combinator may have its own rationale for doing things this way, but here’s one way of looking at it:

  • If you valued your company at £2M before a round (the “pre-money valuation”) and you raised £500K in new cash investment in the round, then by simple arithmetic your valuation after the round will be £2.5M (the “post-money valuation”),.
  • But, if you raised money months beforehand with SeedFASTs or SAFEs, you’ve probably spent that money already, so pretending it’s new money isn’t right. Since you have an obligation to convert it, an investor could put the case that you should therefore regard it as a liability rather than an asset, and hence include it in the new round valuation on an as-already-converted basis.

Are Post Money SAFEs a good idea?

Y Combinator has a blog post with background and reasoning, but it’s pretty impenetrable to any UK founder or investor! Basically, US funding rounds are very different to the UK:

  • in the US, companies may raise millions of $ by SAFEs, then may waityears to do their first priced funding round, often at a valuation of $20M+
  • in the UK, companies raise tens, or hundreds of thousands, of £ with SeedFASTs, then 6 months later convert those in a round with a valuation of £1M or more (and sometimes less).

If you’d raised $1M in SAFEs which converted at a $20M valuation, it would make little difference if it converted at $19M instead.

But, if you raised £500K in SeedFASTs and that converted at £1.5M instead of £2M, that’s a major potentially unexpected dilution.

Post Money SAFEs need careful planning

And that’s the issue we have with Post Money SAFEs, they can be dangerous because they can lead to more dilution than founders were expecting.

Take the following scenario:

  • Jill is planning to raise £500K for her startup.
  • Doing a funding round is tough at the best of times, with Covid it’s even tougher right now.
  • But, thanks to SeedFASTs, Jill doesn’t need to wait for the full £500K, as soon as she finds her first investor she creates a SeedFAST for them, offering them a 10% discount on the valuation paid by new investors in the next round, with an agreed Low Valuation of £2M in case there’s no new round in the next 6 months (HMRC requires that an investment has to convert into shares within 6 months for investors to get their SEIS/EIS).
  • That SeedFAST turned out to be super-fast and easy and, well, pretty soon Jill has done another six SeedFASTs, raising £300K in total. Nice.
  • In fact she’s done such a great job raising with SeedFASTs that there’s no real rush to do that funding round at all, she has all the money she needs for now.
  • But, the six month termination date rolls around all too soon, and the SeedFASTs all need to convert.

And there’s the crunch – with the normal UK way of converting those investments, they would convert at a £2M pre-money valuation.

But, had they been done as Post Money SAFEs, they will convert at a £1.7M valuation, diluting Jill somewhat more than she had originally planned.

In short, if you can model up front the amount you’ll raise by SeedFAST, and you factor that into your valuation and discounts, great, the Post Money SAFE is fine. But, if things don’t go as planned and you raise way more with advanced subscriptions, well, Post Money SAFEs can turn out to cost you a lot more dilution than you had originally planned, so caution is needed here.

SeedLegals now supports YC Post Money SAFEs

All of which is to say that if you’re a UK company that needs to create an investment agreement for a US investor that’s asking for a Post Money SAFE, good news, you can do that on SeedLegals in a few clicks.

Just create your SeedFAST as normal, then select the Y Combinator post-money SAFE option:

By selecting this option, you’ll get a document that’s in English law, with similar language to a regular UK Advanced Subscription Agreement / SeedFAST (so it’s compatible with your next round), but which provides the Post Money conversion wording that matches YC’s SAFE.

BTW, YC’s Post Money approach is being adopted by a growing number of UK funds – so good news, we support those too, our Post Money option works fine for UK investors who ask for this too. Though we do recommend pushing for the standard pre-money valuation UK conversion, if you can.

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