Future equity

What Is Future Equity?

Future equity refers to an agreement where an investor provides capital to a company in exchange for the right to receive an ownership stake at a later date, rather than immediately. This concept is a crucial aspect of early-stage corporate finance, particularly for startups seeking initial investment without undergoing a formal company valuation upfront. The most common form of a future equity agreement is a Simple Agreement for Future Equity (SAFE), which defers the determination of share price until a subsequent funding round.

History and Origin

The concept of future equity, particularly through Simple Agreements for Future Equity (SAFEs), emerged from the need to simplify and streamline early-stage startup financing. Prior to SAFEs, convertible debt was a common instrument for early investments, offering flexibility but often involving complex terms such as interest rates and maturity dates. In late 2013, the renowned startup accelerator Y Combinator introduced the SAFE as an alternative, aiming to create a more founder-friendly and less complicated financial instrument ¹⁹, ²⁰. The SAFE was notably invented by Adeo Ressi, who sought to address the drawbacks of convertible debt by developing a more straightforward investment vehicle¹⁸. This innovation quickly gained traction in the startup ecosystem, becoming a primary method for early seed funding and simplifying the legal and administrative burdens for both companies and investors¹⁶, ¹⁷.

Key Takeaways

Future equity represents a claim on a company's ownership at a future date, typically through a Simple Agreement for Future Equity (SAFE).
It allows startups to raise capital quickly without requiring an immediate, formal valuation.
Investors provide funds upfront in exchange for the right to receive equity shares in a later financing round, often with a discount or a valuation cap.
SAFEs are not debt instruments, meaning they do not accrue interest or have a maturity date.
The conversion of future equity into actual shares usually occurs upon a qualified equity financing event or a company acquisition.

Interpreting the Future Equity

Interpreting a future equity agreement, such as a SAFE, primarily involves understanding the terms under which the initial investment will convert into actual common stock or preferred stock in a future equity round. Key terms typically include a "valuation cap" and a "discount rate." The valuation cap sets a maximum company valuation at which the investor's funds will convert, ensuring they receive a certain minimum percentage of the company if the valuation skyrockets. The discount rate allows the future equity investor to convert their investment at a lower price per share than new investors in the subsequent financing round, compensating them for their early risk¹⁵. Understanding how these terms interact is crucial for both founders and investors to project future ownership percentages and potential dilution.

Hypothetical Example

Consider a new tech startup, "InnovateCo," seeking its initial funding. InnovateCo approaches an angel investor, Alice, for $100,000. Instead of issuing shares immediately or taking on debt, they agree on a future equity arrangement using a SAFE.

The terms of the SAFE include:

Investment Amount: $100,000
Valuation Cap: $5 million
Discount Rate: 20%

A year later, InnovateCo successfully raises a Series A funding round at a pre-money valuation of $10 million, with new investors paying $1.00 per share.

To calculate Alice's conversion:

Calculate the price per share based on the valuation cap: $5,000,000 (cap) / 10,000,000 shares (assumed shares before new money for simplicity, or based on a pre-money valuation of existing shares) = $0.50 per share (cap price).
Calculate the price per share based on the discount: $1.00 (Series A price) * (1 - 0.20) = $0.80 per share (discounted price).
Determine the conversion price: Alice's SAFE converts at the lower of the cap price or the discounted price. In this case, $0.50 is lower than $0.80. So, Alice's investment converts at $0.50 per share.
Calculate shares received: $100,000 (investment) / $0.50 (conversion price) = 200,000 shares.

Alice, as a future equity investor, receives 200,000 shares, effectively acquiring them at a more favorable price than the new Series A investors, rewarding her for her early investment and the risk taken before InnovateCo achieved a higher valuation.

Practical Applications

Future equity agreements, primarily through SAFEs, are widely used in the early stages of private company financing, particularly within the venture capital ecosystem. Their practical applications include:

Startup Fundraising: They provide a quick, cost-effective, and flexible way for nascent companies to raise capital from angel investors and early-stage venture funds without the complexities and legal expenses of traditional equity rounds¹⁴.
Bridge Financing: While often used for initial seed funding, future equity instruments can also serve as bridge financing to help a company sustain operations between larger, priced funding rounds.
Deferred Valuation: For companies without a clear valuation history, future equity allows both parties to defer the company's valuation until a later, more established round of financing, when there is more data to assess the company's worth¹³.
Simplifying Legal Processes: The standardized nature of some future equity agreements, like those published by Y Combinator, reduces the need for extensive legal negotiations and term sheet drafting, accelerating the fundraising process¹². The U.S. Securities and Exchange Commission (SEC) provides guidance on various common startup securities, including Simple Agreements for Future Equity, highlighting their role in early-stage investments¹¹.

Limitations and Criticisms

Despite their advantages, future equity agreements have several limitations and criticisms that both founders and investors should consider. One significant concern is the potential for unexpected dilution for founders if multiple SAFEs are issued before a priced equity round, especially if early agreements lack clear provisions for managing subsequent conversions¹⁰. This can lead to a more complex and difficult-to-manage capitalization table.

For investors, a key drawback is the lack of traditional investor protections found in convertible debt or direct equity investments. SAFEs typically do not have interest rates or maturity dates, meaning there is no guarantee of repayment or fixed return if the startup fails to secure a future equity round or is acquired for a low valuation⁸, ⁹. In such scenarios, investors could lose their entire investment ⁷. Furthermore, future equity investors generally do not have immediate voting rights or control over company decisions until their agreements convert into actual shares, which limits their influence during the crucial early stages of a company's development⁶. Therefore, conducting thorough due diligence remains essential for all parties involved.

Future Equity vs. Convertible Note

While both future equity agreements (like SAFEs) and convertible notes are popular early-stage financing instruments that allow investors to convert their investment into equity at a later date, they possess fundamental differences.

A future equity agreement, such as a SAFE, is generally not considered a debt instrument. It does not accrue interest, nor does it typically have a maturity date by which the company must either repay the investment or convert it to equity. This structure offers simplicity and flexibility, allowing companies to avoid immediate debt obligations and focus on growth. The investor's return is purely tied to the company's future equity value.

In contrast, a convertible note is a form of short-term debt. It functions as a loan that accrues interest and has a defined maturity date. At maturity, or upon a qualified funding round, the note can either be repaid with interest or convert into equity based on pre-agreed terms, often including a discount or valuation cap³, ⁴, ⁵. Because it is debt, convertible notes typically provide investors with a senior claim on the company's assets in a liquidation event compared to pure equity holders, offering a layer of downside protection not usually present in SAFEs¹, ². The choice between the two often depends on the specific needs of the startup, the preferences of the investors, and the desired balance between simplicity and investor protection.

FAQs

What is the primary benefit of future equity for a startup?

The primary benefit of future equity for a startup is the ability to raise capital quickly and efficiently without having to determine an immediate, precise valuation for the company. This streamlines the fundraising process, reducing legal costs and time spent on negotiations.

Do investors in future equity receive voting rights immediately?

No, investors in future equity agreements typically do not receive voting rights or direct ownership until their investment converts into actual shares during a subsequent equity financing round or other agreed-upon trigger event.

Can future equity convert into different types of shares?

Yes, future equity agreements usually specify that the investment will convert into the same type of preferred stock issued to new investors in the next qualified funding round. However, the specific terms, such as a valuation cap or discount, ensure that the future equity investor often receives shares at a more favorable price per share than later investors.

What happens if a startup with future equity agreements never raises another funding round?

If a startup with future equity agreements never raises another priced funding round or experiences an exit strategy (like an acquisition or IPO), the future equity might never convert into equity. In such scenarios, investors could potentially lose their entire investment, as these agreements are not debt and typically have no repayment obligation.

Is future equity suitable for all types of businesses?

Future equity is predominantly used by early-stage, high-growth potential companies, particularly technology startups, that anticipate future, larger funding rounds at significantly higher valuations. It may not be suitable for businesses with slower growth trajectories or those that do not intend to raise subsequent institutional capital.