Start-up valuations are under pressure in late 2022. Both companies and investors are increasingly struggling to finance business models that rely on external financing. Where the challenge of closing a financing round is already having a negative effect on the business, so-called future equity agreements offer an interesting solution. These future equity investments are paid immediately but are only converted into shares in a later financing round, often saving companies from running out of financial runway.
The music is slowing
After years of steadily rising start-up valuations, the rally recently took a pause. Start-ups are now facing difficulties raising financing rounds while their cash burn remains high. Many businesses that require frequent financing rounds as competition often requires hypergrowth and burning cash at an ever-rising pace. Raising more money upfront would often dilute founders below a level where they can be expected to have enough "skin in the game" once it comes time to exit. Cutting costs to extend financial runways is somewhat limited if the resources built up by investors' money are to be preserved. As a result, short runways are the rule rather than the exception, and external financing is necessary to produce relief.
Don't be sorry
As companies approach the end of their current runway, raising financing becomes more important every day up until the point where it overly distracts management from their "other" job of developing the product and company. If the end of the runway is already visible, the struggle to close a financing round often negatively affects the business by excessively underfinancing certain areas and focusing management's attention on the company's money problems.
To avoid such financial distress, future equity is becoming increasingly popular. The most prominent version of this investment instrument is a "SAFE" – the simple agreement for future equity (SAFE) by Y Combinator. Under a SAFE, an investor initially invests in the company without an agreed valuation and does not immediately receive shares in the company. SAFE investors receive shares in the company later in the course of a (usually qualified) financing round, i.e. when investors invest new money in the company through a capital increase. The valuation agreed in this later financing round is then used to determine the number of shares issued to SAFE investors.
"Bait" for SAFE investors
As with convertible loans, investors are typically granted a discount in exchange for the higher risk associated with their earlier investment as compared to the priced round investors. Typically, an absolute valuation cap is also agreed. If the company does not raise a (qualified) financing round, the investors will still receive shares in the company at an agreed (lower) minimum valuation on a pre-agreed long stop date. As a result, founders need to convince investors to finance them via a priced (qualified) round before the long stop date if they want to avoid being diluted at the pre-agreed minimum valuation.
Why being SAFE can make sense
SAFEs spare the company and the investor from pricing a financing round, as the SAFE share price is determined in the later (priced) financing round. This means faster execution and simpler documents, which is helpful in the case of liquidity problems and offers a solution to overcome cyclical lows. This is especially true where founders are convinced of an upward trend and currently cannot finance themselves at a valuation acceptable to them. Compared to convertible loans, SAFEs can make a difference for the benefit of all parties from an Austrian taxation point-of-view. The disadvantage of SAFE investments not being repayable is in our view rather theoretical. In practice, convertible loans are de facto always converted.