Venture Capital – The Death of the SAFE?

Despite recent and significant turmoil worldwide (including regional conflicts, rising inflation and interest rates, volatile capital markets and continuing supply chain issues), global venture capital investment remained robust (if not as strong as 2021) in 2022 and early 2023.

Although some remain wary, investors appear keen to continue to put their dry powder to use, particularly in early-stage start-ups where the potential multiples are most attractive. This is definitely true in the Middle East where there is significant liquidity and such capital needs to be deployed, therefore making venture capital investments more appetising, particularly in high-potential growth sectors, such as healthcare and technology, on a worldwide basis.

However, the investment landscape is changing. Whilst founders still come to the table expecting a standardised Simple Agreement for Future Equity (SAFE) to be used as an investment mechanism, we are seeing more and more investors pushing back on this and expecting something constituting a more formal investment agreement to be put in place to offer the investor more protection and control over its investment (particularly for higher value investments). Below, we consider what these new investment agreements may cover and whether this is truly the death of the SAFE.

Redressing the balance of risk

During the technology boom of the 90s and 00s, the balance of risk leaned in favour of the start-ups and their founders, out of which the traditional SAFE was born. A short-form investment agreement suited the start-ups and their founders in allowing them to retain control over the target entity, in an environment where funding was more readily available and the potential for fast, high-growth was more commonplace.

However, with start-ups still in need of significant funding, but with an increase in competition for such funding and investment scrutiny by investors (and often internal controls for institutional investors), it is becoming increasingly commonplace that start-ups (and their founders) are having to, and are more willing to accept the need to, enter into a more formal/rigid investment agreement, which may cover the following:

• Business-related warranties –investors are increasingly keen to ensure the position of the Company is ‘as expected’, particularly given the nature of venture capital investments where more limited due diligence exercises are undertaken than on typical M&A transactions. As such, warranties given by Founders and/or the Company itself should be expected, and start-ups should be ready to conduct a disclosure exercise prior to receiving funds.
• Investor rights –whilst board seats, reserved matters and information rights may typically have been reserved for later-stage equity financings, more investors are looking to secure these controls at an earlier stage. This is both a reflection on the market and on tightening internal controls, where investors are looking to ensure they are well-informed and have voting rights in key areas.
• Repayment provisions –with investors utilising a combination of SAFEs and convertible notes, we are increasingly finding investors seeking water-tight repayment mechanisms not only in insolvency situations but also as a contractual remedy – such as where material breaches of warranty occur and/or the business of the start-up is suspended for a set period of time.
• Use of funds – we are also seeing that investors are imposing more controls over the use of their investment, including mandating that their funds should not be used to pay for claims brought by other investors for breaches of warranties or to settle any existing third party disputes and/or debts, which would ultimately not add to the value of the business.
• Wider considerations – with an increasing volume of cross-border venture capital investment, particularly in jurisdictions with synergies to that of the investor, specific clauses are being added to investment documentation governing foreign investment restrictions and/or target country notification processes. Both investors and start-ups need to be aware of such requirements, with start-ups needing to be ready to file notifications where required (by law, or in the opinion of the investor) at their own cost.

Is the more formal investment agreement here to stay?

Whether the more formal investment agreement is here to stay remains to be seen, but in the current economic climate, we expect we will be seeing more of these over the coming months/years rather than the customary SAFE. There may be a swing in the opposite direction if there is a new ‘boom’ sector (and venture capital targets can command a willing audience), however whether investors will be willing to forego their additional protections to which they have once more become accustomed, will certainly be interesting to see.