First round of financing: Convertible Loan Agreement (CLA) or Simple Agreement for Future Equity (SAFE)
Opening a company and starting a business is not an easy task, and at the first stages of building a serious business from a start-up, founders resort to seeking additional funding.
And now you, as a funder, have coped with the first difficult tasks: you have come up with your product, started working on it, opened a company and even found an investor who is ready to help you financially, but what next? How do you legally formalise the transfer of money? These are the cases for which investment instruments such as SAFE and CLA are most often used. Let's take a look at how they work.
What is SAFE
SAFE (or simple agreement for future equity) is a financing agreement that gives the investor the right to receive equity upon the occurrence of a certain event in the future.
A standardised SAFE text was developed by startup accelerator Y Combinator in 2013 to simplify the early funding process. Typically, 90% of the time, the terms of a standardised SAFE are not modified.
SAFE is not a loan or debt instrument, so the company has no obligation to pay interest on the use of the funds and repay the debt after a certain period.
Simply put, a SAFE investor cannot demand conversion of money into shares if such conversion has not occurred after a certain period of time. He will wait for the conversion event to occur, which may occur either in the near future or after a long period of time, or may not occur at all.
What is CLA
A CLA is a form of debt that allows an investor, in return for the money provided to a startup, to receive shares in the company if certain conversion events occur.
Since CLA is a type of debt, it accrues interest. And then there are two scenarios for the startup:
- if a conversion event occurs within the period agreed upon by the parties, the investor receives a certain number of shares in return for the money previously provided, or
- if the conversion event has not occurred, the investor may choose to repay the loan with accrued interest or convert the loan into shares based on the current valuation of the company.
What are the similarities between SAFE and CLA and why are they being compared?
The similarity of these two financing arrangements is that the main purpose of the two contracts is to convert cash into shares in the company.
Speaking of differences, the following are worth mentioning:
- Debt: SAFE, unlike CLA, is not a form of debt. CLA is necessarily repayable either by a certain number of shares or by repayment of money with interest. SAFE is repayable only upon the occurrence of certain events and only by conversion into shares.
- Deadline: The CLA sets a deadline within which a conversion event must occur. SAFE obligations are not time-limited: they remain in place until the conversion event occurs.
- Interest: Since CLA is a debt, interest accrues on it. SAFE has no such condition.
What are the advantages of SAFE and CLA?
If we evaluate the way SAFE and CLA work, each definitely has both pros and cons for both funders and investors.
Advantages of SAFE:
- No interest rate and no conversion period.
This feature is definitely an advantage for the investor, but at the same time it is a clear disadvantage for the investor, because, firstly, the investor can wait a long time for a new round of investment to receive the promised shares, and, secondly, the investor may not recoup his investment in the event of the company's bankruptcy, since no interest is accrued on SAFEs.
- There is virtually no need to agree on terms and conditions;
- The use of standardised SAFE text reduces legal costs.
In turn, the benefits of CLA are:
- More flexible conversion terms;
- More common among investors, as it represents a less risky type of financing;
- Availability of an interest rate and a maturity date (a definite advantage for investors). This means that this type of financing is safer for the investor, as it allows the money to be returned with accrued interest.
When, to whom, and what to use?
Based on the guarantees given to the investor under the terms of the CLA, it is safer for the investor to use the CLA. For the funder, especially in the early stages of financing, it is more favourable to use SAFE, as it deprives him of the obligation to return the money after a certain period.
At the same time, the final choice of investment mechanism depends on how these instruments will work in the existing realities of interaction between the investor and the investor.
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