What is a SAFE?
A Simple Agreement for Future Equity (SAFE) is a flexible investment contract that enables startups to secure funding without immediately surrendering equity. Investors provide capital in return for the future right to equity, subject to specific terms. Unlike debt financing, SAFEs don’t necessitate interest payments, have no maturity date, and aren’t loans to be repaid. Instead, they grant the right to future company shares upon a triggering event like a financing round or liquidity event.
SAFEs are typically simpler and more adaptable than other investment agreements like priced equity rounds, convertible debt, and traditional equity financing, making them attractive to both investors and startups. Key elements of a SAFE include the investment amount, valuation cap, and conversion trigger.
A significant advantage of a SAFE is its simplicity and flexibility, allowing startups to raise capital without surrendering equity or incurring debt. It also provides investors with the potential for increased equity if the company’s valuation rises. However, it’s crucial to thoroughly review and negotiate the agreement terms to ensure alignment with both the investor’s and startup’s needs and objectives.
Unlike priced equity rounds that involve selling shares at a fixed price, SAFEs offer the option to convert the investment into equity later, based on a valuation cap or other terms. This benefits startups by enabling them to raise capital without having to establish their company’s value at the investment time.
The Key Terms of a SAFE
The principal terms of a SAFE, including the valuation cap, discount rate, and conversion trigger, can significantly influence investors’ potential returns and startups’ capacity to secure future funding:
- Valuation cap: This is the highest valuation at which the investor’s contribution can convert into equity. It safeguards the investor from paying excessively for equity if the startup’s valuation substantially escalates.
- Discount rate: This is the percentage discount that the investor will obtain on the future valuation of the company when the investment converts into equity. It rewards the investor for their early involvement in the company’s growth.
- Conversion trigger: This is the event that initiates the conversion of the investment into equity. It could be a future financing round, a merger or acquisition, or any other agreed-upon event. It’s crucial for both parties to concur on the conversion trigger and the conversion timeline, as these can impact the investor’s potential returns and the startup’s capability to raise future capital.
How do SAFEs work?
If you’re contemplating investing in, or procuring funds for, an early-stage startup, a SAFE might be on your radar. Here’s a detailed step-by-step guide on how SAFEs generally operate:
- The investor supplies funding to the startup in return for the right to convert that funding into equity at a future date.
- A specific event, such as a future financing round or a startup acquisition, triggers the conversion. This implies that the investor’s funding will only convert into equity if and when the triggering event takes place.
- The conversion terms, including the valuation cap and the discount rate, are negotiated between the investor and the startup. The valuation cap establishes the maximum valuation at which the SAFE can convert into equity, while the discount rate applies a percentage discount to the valuation cap at the time of conversion.
- Until the conversion takes place, the investor doesn’t own any equity in the startup and isn’t entitled to any dividends or interest payments. This means that the investor’s return on investment hinges entirely on the startup’s success and the conversion terms.
In summary, SAFEs offer a flexible and simple method for startups to raise capital, while providing investors with the potential for high returns at a relatively low risk. However, it’s crucial to thoroughly review the agreement terms and negotiate for conditions that align with both the investor’s and startup’s needs and objectives.
History of SAFEs
SAFEs were created by Y Combinator, a startup accelerator, in 2013. They were designed to be a simpler, more efficient alternative to convertible notes, providing a way for startups to secure funding without the complexities of debt financing.
Why is SAFE Welcomed by Startups?
SAFEs are welcomed by startups because they are simple, quick, and cost-effective. They don’t require interest payments or have a maturity date, reducing the administrative burden on the startup. They also allow startups to raise capital without setting a valuation, which can be challenging in the early stages of a company.
Advantages of SAFE for Startups
The advantages of SAFE for startups include speed, simplicity, and flexibility. SAFEs allow startups to secure funding quickly without the need for lengthy negotiations. They are also straightforward, with fewer terms and conditions than other financing instruments. Furthermore, they offer flexibility as they convert into equity at a future date, allowing the startup to defer valuation until it has more information.
SAFEs vs Convertible Notes
While SAFEs and convertible notes are similar in that they both provide a mechanism for an investor to provide capital in return for future equity, there are key differences. Convertible notes are debt instruments that accrue interest and have a maturity date, while SAFEs are not debt, do not accrue interest, and do not have a maturity date.
SAFE vs Traditional Equity Financing
Compared to traditional equity financing, SAFEs are simpler and faster. Traditional equity financing involves setting a valuation and negotiating share price, which can be time-consuming and complex. In contrast, SAFEs allow startups to raise capital quickly without setting a valuation.
Drawbacks and Considerations When Using SAFEs
While SAFEs have many advantages, there are also drawbacks and considerations. For investors, the main drawback is that SAFEs do not provide any control rights or dividends, as they are not equity until converted. For startups, SAFEs can lead to future dilution, which means the founders’ ownership stake in the company may decrease when SAFEs convert into equity. Therefore, it’s important for both parties to understand the implications of SAFEs before entering into an agreement.
What is the function of the conversion trigger?
The conversion trigger is a specific event or milestone that initiates the conversion of the SAFE into equity. This could be a subsequent financing round or a liquidity event, as stipulated in the agreement.
What occurs if the startup is bought or goes public before the SAFE converts into equity?
If the startup is purchased or goes public before the SAFE converts into equity, the investor may have the choice to receive the cash equivalent of their investment, as specified in the agreement’s terms.
Why would one opt for a SAFE over a convertible note?
A SAFE’s appeal lies in its lack of an interest rate, making it more appealing to startups looking to avoid debt. Also, while a convertible note’s conversion trigger is usually event-specific, a SAFE’s conversion trigger is generally based on a future financing round, offering more flexibility for startups.
What are the crucial terms to examine and negotiate in a SAFE?
Key terms in a SAFE to review and negotiate include the valuation cap, discount rate, conversion trigger, among others. The valuation cap sets a maximum price for the investment’s conversion into equity, while the discount rate incentivizes investors to invest in the startup. The conversion trigger outlines the conditions under which the investment will convert into equity.
Can SAFEs be utilized in multiple financing rounds?
Yes, SAFEs can be employed in multiple financing rounds, provided the agreement’s terms permit it.
How are SAFEs taxed?
SAFE taxation can be complex and depends on several factors, including the agreement’s specific terms and the tax laws in the jurisdiction where the investment is made. Both startups and investors should consult with experienced tax professionals to understand the tax implications of investing in a SAFE.
How does a SAFE compare to a priced equity round?
A SAFE and a priced round are distinct types of investment agreements with different structures and terms. A priced equity round involves selling shares at a fixed price, while a SAFE offers the option to convert the investment into equity later, based on the agreement’s terms.
