February 13, 2024

'Safer' Strategies: Rethinking Startup Investment

A case study from my initial experience pricing Safer investment transactions for early stage companies

'Safer' Strategies: Rethinking Startup Investment

In the past, entrepreneurs traditionally sought capital from angel investors and venture capitalists leveraging instruments like Simple Agreements for Future Equity (SAFE) or convertible notes. These tools have dominated early-stage funding over the past decade, offering startups a means to secure investment where the principal value proposition is not immediately valuing their company, thereby deferring equity valuation discussions to future financing rounds or triggering events.

SAFE agreements and convertible notes advocates purport these instruments cater to founders. SAFE agreements for allowing equity conversion during future financing rounds without immediate valuation, while convertible notes, essentially debt instruments, convert into equity upon certain financing milestones, theoretically balancing flexibility for both investors and startups with their maturity dates and interest rates.

However, I argue that these instruments are preliminary steps in the process equity incursion, as I have previously explained.

Instead, I have chosen to base my own investment practice around the Simple Agreement for Future Equity with Repurchase (Safer) model, which Next Wave Partners open sourced last year. Safer represents a fusion of equity investment and revenue-based financing, where startups commit to repurchasing shares using future revenues, thus offering investors returns tied directly to company performance. This model not only provides capital but aligns investor and founder interests through a performance-based return mechanism.

As a fund manager, assessing startup risk is a critical function.

The following analysis provides a live look at a portfolio company that I worked with last year.

Portfolio Company Backdrop

In this case study, the founder faced a unique challenge and opportunity. In the years preceding our work together, he had been piloting a new commerce initiative based on a niche market strategy. In a way, he was executing a classic startup boot strapped incubation process.

His service offering had grown to sufficient maturity that a decision had to be made about how best to accelerate the business.

After careful analysis we determined the best course of action would be to execute a spin out and to raise venture capital to fund the resulting new company as a separate going concern.

After months of work we determined the new spin out would need about $2M in seed capital to build on the success of the pilot operations.

How I Priced the Safer Investment

The following table reflects how I priced the round for the company using a Safer:

Example Safer pricing table

The mechanics of Safer pricing involve a series of calculations, from setting target returns to determining the repurchase amounts and payments, ultimately dictating the investment's conversion into equity. These elements are designed to adapt the financing structure to the company's revenue performance, ensuring that investment returns reflect actual growth and success. Here is an explanation of what is going on in this table:

  1. Target Return: =purchase_amount*target_return_percentage
    • This calculates the investment return by multiplying the purchase amount by the targe return percentage. This is the most important level to adjust risk in Safer pricing.
  2. Repurchase Amount: =purchase_amount * repurchase_percentage
    • This calculates the repurchase amount by multiplying the purchase_amount by the repurchase_percentage. This determines how much of the initial purchase amount is subject to repurchase under certain conditions.
  3. Repurchase Payments: =min((revenue*revenue_percent),target_return)
    • This takes the minimum of two values: The product of the values in revenue cell and the revenue percent cell, and the value in the target return cell. This calculates the amount of the Safer repurchased based on the hypothetical variable of accrued revenue
  4. Safer Amount =purchase_amount - ((repurchase_payments / target_return) * repurchase_amount) + (target_return - repurchase_payments)
    • This adjusts the purchase amount by subtracting the product of repurchase payments divided by the target return, multiplied by the repurchase amount, and then adding the difference between the target return and repurchase payments. This is the total amount of unpaid value that will be converted to equity at the valuation cap number prior to a liquidity event.
  5. Liquidity Price: =valuation_cap/liquidity_capitalization
    • This is the price per share derived by dividing a valuation cap by the total capitalization at liquidity.
  6. Conversion Amount: =safer_amount/liquidity_price
    • This calculates the number of shares or units acquired by dividing the amount invested through a Safer by the price per share or unit at liquidity. It indicates how many shares an investment converts into at the time of a liquidity event.
  7. Total Safer Return: =conversion_value+repurchase_payments
    • This adds the conversion value (the value of the investment converted into equity or its equivalent) to the repurchase payments. It reflects the total return to the investor, including both the equity value received and any repurchase amounts.

The portfolio company was already generating revenue, but their projected growth model still relied on several assumptions. The company forecasted slightly over $34M in accrued revenue over the first four years. Considering the extensive work we put into preparing the company for capital raising, I concurred the forecast was adequately conservative.

Pricing this transaction at a 185% return, while retaining 10% of the Safer amount to be converted to equity upon the sale of the company, achieved the right risk balance for both investors and the founder.

In traditional venture capital pricing, dilution refers to the decrease in a founder's ownership stake due to the issuance of new shares to investors. When comparing the expected performance of a Safer investment with traditional venture capital pricing, which uses accrued interest and liquidation preference multiples to dilute founders, the anticipated percent of liquidity returned would be close to par.

This was acceptable to everyone involved, but especially for founders because the Safer terms don't come with the ratchets and control mechanisms that I wrote about when I described the sorcery of traditional venture finance.

Returns on par with typical VC, but without the protective provisions and board seats!

Returning Value to Those that Create It

It is when you consider the scenario of over performance that the Safer truly shows its value for founders.

Consider the following example scenario in which the portfolio company exceeds both original revenue generation and liquidity price expectations.

Exceeding expectations favors the founders

As I’ve explained about the Venture Capital Ethos, traditional VC investors often behave irrationally, ironically, when companies begin to demonstrate an accelerated performance trajectory. In their pursuit of high returns, they often resort to drastic and poorly conceived interventions that can ultimately lead to catastrophic events for the business. These irrational interventions range from schemes and scams to extricate the founders and harvest their equity to nefariously over-hyping the business to maximize secondary market values without considering the long-term sustainability of the business or the people that run it.

Unfortunately, these interventions often create serious problems for the company, and for the investors themselves. They can disrupt the company's operations, demoralize the team and drive painful turnover, and divert resources away from the core business. This can further jeopardize the company's ability to generate returns and ultimately result in its downfall, as we are now witnessing among the Power Law Cartel.

By achieving the target return solely through revenue proceeds, the portfolio company significantly changes the proportion of liquidity returned. In the given example, this translates to a 13x better outcome compared to traditional venture capital investment.

As an investor, I believe that if a company over performs, the majority of the value returned should go to the founders and the employees that created that value.

My practice is evolving and growing, but initial data points to the Safer model as a way to mitigate the potential for dilution common in traditional venture capital, providing a safeguard for founders against the variability of business performance. This approach contrasts sharply with conventional venture capital's modus operandi, offering a more sustainable path for growth and governance.

Perhaps most importantly, the Safer model champions the principle that the primary beneficiaries of a company's success should be the individuals directly responsible for its value creation. By prioritizing returns to founders and employees, the Safer underscores a commitment to venture reciprocity.