Startups need funds to thrive, either internally or externally generated by the business. This external sourcing may involve seeking funds from venture capitalists, angel investors, private equity organizations, etc. For early-stage startups without valuation, seeking funds to run your business may be a hassle, especially those without valuations, and that’s where simple agreements for future equity (SAFEs) come in as a solution for startups and likely investors.
Key takeaways
- SAFEs give investors future equity rights in a startup.
- SAFE agreements are easy and flexible, especially for startups that have yet to have valuations.
- SAFE notes are different from convertible notes and aren’t considered debt.
- These agreements carry legal and financial implications and require the input of legal experts from both parties.
What is a SAFE agreement?
A Simple Agreement for Future Equity (SAFE) is a contractual agreement that gives investors future equity rights in a startup company, typically in its early stage.
This kind of agreement is common among early-stage startups because it’s flexible, interest-free, and helps them bypass the need to have a valuation before raising funds for their business. For investors, SAFE agreements promise high returns and provide a sure path to exit. Investors only get to convert their investment into equity when a trigger event like a new funding round, IPO, or acquisition occurs. This conversion usually occurs at the minimum valuation cap set at the time of the funding, and it’s redeemed at a discount agreed upon in the SAFE.
SAFEs serve as a favorable alternative to convertible notes, in which the investment is regarded as debt that accrues interest and has a maturity date when the company must repay its debt.
Key terms and concepts in a SAFE agreement
If you are looking to raise or invest funds through a SAFE agreement, here are concepts to look out for:
Valuation cap: This is the maximum value at which an investor can convert its SAFE into equity. The valuation cap is typically preagreed and tends to reward investors for taking risks as early investors in a startup. If a triggering event occurs, for example, a new funding round, and pushes a startup whose SAFE valuation cap was $1 million to a valuation of $4 million, the equity for the investor from the SAFE agreement will be calculated based on the initial valuation cap and not the new valuation.
Discount rate: this percentage enables investors to convert their investment at a lower share price during a trigger event.
Conversion triggers: These are also known as triggering events that activate a SAFE for equity conversion. A conversion event could be an equity financing round where a business raises funds in return for issuing shares at a particular price or when the business is acquired or IPOs.
Pro rata rights: This clause in SAFE gives investors the right to buy more shares in future funding rounds. Investors usually do this to help them maintain their status as part owners of a business; however, the clause isn't an obligation.
Most-Favoured-Nation (MFN) Clause: The MFN clause is an agreement that ensures that businesses offer their SAFE investors the best terms possible in future SAFEs or funding rounds.
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Pre-money valuation: Pre-money valuation is the value of a company before it raises any external funding, including SAFEs. When this is introduced into SAFE arrangements, it's referred to as pre-money SAFEs. This valuation shows how much your startup is worth before it receives any investment.
Pre-money SAFEs are favorable to investors as there's the potential for their investment to yield larger returns. Say investor A gives Startup B $200,000 via a pre-money SAFE with a valuation cap of $5 million, and the next funding round sets the company's valuation at $10 million; then, investor A's SAFE would be converted to equity at the company's initial valuation of $5 million. This means a larger share of equity in the business for the investor.
Post-money valuation: Post-money valuation refers to the worth of a company after it has received money from investors. Unlike pre-money, where the valuation is determined before the funding, post-money valuation considers the investment before a valuation is reached. SAFEs that are reached using this valuation are called post-money SAFEs and tend to favor both startups and investors in terms of the estimable outcomes of their investment.
Difference between SAFEs, convertible notes, and equity financing
Investors use SAFEs as a funding option when investing in early-stage startups. It benefits startups because such investments are not considered debts and allow the startup to build and continue operations until a conversion event is triggered. For investors, it’s a comfortable route because it’s faster compared to other financing options and holds the promise of high returns.
SAFEs provide an alternative to financing options such as convertible notes and equity financing. Convertible notes are a funding round with a triggering event where an investor converts their investment into equity. However, it’s also a loan that accrues interest and is expected to be converted when the loan reaches maturity. If the conversion doesn’t happen during the projected maturity date, the note is expected to be repaid to the investor or converted to equity.
Convertible notes ensure that there’s a sure pathway to exit for investors. It can be beneficial for startups if there’s a sure pathway for faster growth and another financing round soon. However, with convertible notes, there’s the risk of more dilution for the founders due to the interest in the note.
Equity financing, on the other hand, is another financing option that investors look upon favorably because it gives them more control over the business because they get a stake in the company in return for their capital. For startups, it makes the investor an active stakeholder and increases their participation to see the business's success.
However, it can lead to more interference from investors in decision-making, which may affect founder autonomy. A major challenge of equity financing is that it requires the founders to set a valuation for the company. The process usually takes longer due to negotiations and a host of legal documentation.
The challenges of convertible notes and equity financing for startups are mostly addressed in a SAFE and unburden them with the fear of accruing debt, slow-paced negotiations due to traditional financing complexities and the need to set a valuation beforehand.
Structuring a SAFE agreement
SAFEs usually come with or without a valuation cap, with a discount or without a discount, giving it different variations, which, according to Y Combinator, are:
- Valuation cap, no discount: As the term goes, these SAFEs ensure that the startup has a valuation cap in the agreement but doesn’t include a discount for the investor upon conversion.
- Discount, no valuation cap: This is an agreement where the conversion event is triggered with a discount for the investor. Startups usually reach this agreement without valuation caps.
- Most-Favored-Nation (MFN) clause: This clause involves no valuation cap and no discount, but it ensures that the investors in SAFE get the best deals offered to future investors in future funding events. MFNs are not as popular as the above options, as most investors prefer to invest in a startup with a valuation cap.
While there may be little tweaks to a SAFE, most agreements are standardized, contributing to the agreements' flexibility.
Legal and financial considerations when entering a SAFE agreement
It's crucial to consider a SAFE's legal and tax implications before committing to it as a source of financing.
Legal considerations
- Drafting and execution of SAFEs: Attention to detail is an essential requirement when it comes to drafting SAFEs. It usually requires the input of legal experts to protect your rights as an investor or startup. The agreement will include the valuation cap and discount rates depending on the type of SAFE. Also, it will contain the triggering event.
- Compliance with regulations: SAFEs have to comply with the relevant laws pertaining to it. This also means that all the information provided in the SAFE must be accurate and complete upon filing with the appropriate regulatory authorities.
Tax considerations
There are various tax considerations when it comes to SAFEs, and top among them is a capital gains tax.
Capital gains tax: There's the possibility that investors may be subject to capital gains tax upon an increase in the value of their investment due to equity conversion of their SAFE.
Advantages and disadvantages of SAFE agreements
Advantages
- A SAFE isn’t a debt. This is one of the major differences between a convertible note and a SAFE. The financing raised from a SAFE doesn’t read as negative on the startup's balance sheet and it doesn’t accrue interest.
- SAFEs are easy to issue: Due to the nature of these agreements (they don’t vary much from place to place), they are relatively simple and fast to issue.
- Investors stand to gain a lot from SAFEs should the exit event successfully occur, as they get more benefits than future stockholders.
- SAFEs provide early-stage startup founders access to investors who offer capital, mentorship, networking opportunities, and industry expertise.
- Should the startup fail, they are not obliged to repay the investors.
Disadvantages
- There's the risk of high dilution for the founders and other shareholders when the startup valuation at the point of conversion is relatively higher than the valuation of the startup in the SAFE agreement.
- Investors risk earning no returns from their investment should the startup fail.
- Future valuations may not align with investor expectations, leading to conflict between founders and investors as there will be uncertainty around the future equity valuation.
- The terms of a SAFE can deter or negatively impact new and future investments, especially if the startup has multiple SAFE agreements.
FAQs about SAFE agreements
Can a SAFE agreement be changed after signing?
It is difficult to change a SAFE agreement after signing. Therefore, it’s essential that you go through the agreement thoroughly and consult a lawyer before signing.
When does a SAFE convert into equity?
A SAFE converts into equity when a trigger event, such as a new financing round or acquisition, occurs.
What are the risks of using SAFE?
For startups, there is a risk of dilution for both founders and new investors, which decreases their ownership stake and increases the potential for a loss of control. For investors, there is the risk that the SAFE (Simple Agreement for Future Equity) may not convert to equity, meaning they might never receive a return on their investment. Additionally, investors do not gain voting rights in the company until a later date, and there is a possibility that this may never occur.
Before you sign that SAFE contract
SAFEs are arguably one of the easiest ways for startups to enter the fundraising arena, as they bypass many requirements that investors typically consider before investing. Since Y Combinator introduced SAFEs to the startup ecosystem, they have significantly impacted how startups secure funding, and your startup could benefit from such an agreement.
However, investors and startups must reach an agreement that works for everyone involved, ensuring that no one feels cheated. Due to their simplicity and potential, SAFEs are likely to remain popular in the future. Therefore, both parties need to consult with legal and tax professionals to ensure clarity and fairness in the process. This will help mitigate any potential misalignment down the line.