What is a Simple Agreement For Future Equity (SAFE)?
‘SAFE’ stands for Simple Agreement for Equity Finance. It is a relatively new type of contract created by the American seed money start-up accelerator YCombinator in 2013. It is a simple agreement popularly used as a form of financing contract that may be used by start-ups as a means to raise capital during the early stages of the company known as the seed financing stage. The agreement purports to create and provide future equity which will hopefully gain significant value in the company in future in exchange for capital to the company.
How Does a SAFE Work?
The SAFE contract is usually signed between an investor and the start-up and gives the investor the right to receive equity of the company on certain events occurring such as the sale of the company or future equity financing. Although, the investor does not obtain the equity until one of the triggers listed in the SAFE agreement is met.
Terms and Rights Fundamental to a SAFE Agreement
There are some terms and rights fundamental to a SAFE agreement that are vital for founders and for investors to know of;
- Conversion terms – the terms must be clear on the amount that gets invested that turns to equity.
- Repurchase rights – there may be some provisions that allow founders to repurchase the future right to equity before it turns into equity.
- Dissolution rights – the terms for what occurs if the company is dissolved must be clearly written out in the SAFE agreement.
- Voting rights – SAFEs do not represent current equity stakes in the company for investors and therefore do not provide the investors with any voting rights in the early stages of a company.
Are SAFEs good for Entrepreneurs and Start-ups founders?
A Critical element of SAFE agreements is that they enable high resolution funding. Both parties can close a deal when both are ready to sign and wire the money. The transparency that a SAFE agreement provides and the certainty it gives on what both the investor and the start-up is giving and getting, allows for a more efficient process.
It is regarded as amore founder-friendly investment contract than the alternative which are convertible notes. They are both similar in the fact that they both create future equity for an investor during a preferred valuation stock round and can include discounts or valuation caps. With the valuation cap the investor is entitled to equity at the price of the cap. In contrast to SAFE agreements, convertible notes act as debt instruments and thus with convertible notes if the company fails they have the burden of having to pay back the investor. This is not the case with SAFE agreements. The strict obligations in convertible notes can cause a company stress and can even bring the end to a company, therefore the SAFE agreements in the form of equity funding avoids the problem of a company taking on debt. Unlike convertible notes, SAFEs do not accrue interest as a loan does and do not have a specific maturity date.
As a result of not having a maturity date, start-ups save money in legal fees by reducing the time spent on extending maturity dates and revising interests, thus we can see the advantage in using SAFEs over convertible notes.
However, issues can arise using SAFE agreements and care must be taken when drafting these agreements. The more SAFE agreements that are issued the less shares the founders have which could be unappealing for venture capitalists in future rounds of financing. Multiple valuation caps in multiple SAFE agreements can adversely affect the capitalisation table and can negatively impact the financial viability of the company.
It is critically important for founders to understand the impact a SAFE agreement has on the dilution of shares and for investors to appreciate the percentage ownership in the company they have purchased. This where it becomes important to have a very experienced legal team involved with guiding the transaction/s.
It is also why in 2018 YCombinator introduced the terms ‘pre-money’ SAFEs and ‘post-money’ SAFEs and advised companies to treat them as wholly separate financings to simplify the process. They said that the ‘post-money’ has the advantage of being able to ‘calculate immediately and precisely how much ownership of the company has been sold’.]
Are SAFEs Good for Investors?
Having comparatively evaluated the advantages and disadvantages of a SAFE agreement , let’s consider how SAFE agreements can also be beneficial to investors. Always remember that there is always a risk of providing funding to an unproven company, so there has to be some upside to attract investors.
In general, the benefit to investors is that they have a right to purchase shares under favourable terms upon some future event. For example, with the valuation cap in most cases if the company’s value is astronomically high, it guarantees the investor a certain amount of equity regardless of the valuation. Moreover, there are pro rata rights which allow investors to participate further in future financing rounds but these are normally reserved for investors who contributed significantly to the start-up in its early stages.
There are a number of benefits the use of SAFEs can provide to an entrepreneur or founder of an early-stage company in creating SAFE agreements. The simplicity and cost-effective nature of these agreements allow for an easier means to raise funds. It may however not be suitable for all financing situations and it is of particular importance that the parties involved in the agreement have the SAFE agreement reviewed and have investigated all other options before deciding to pursue with SAFE.