- SAFE Agreements Simplify Fundraising: Offers a straightforward and efficient way for startups to raise funds without the complexities of traditional equity financing, benefiting both founders and investors.
- Post-Money Valuation Enhances Transparency: The introduction of post-money agreements by Y Combinator in 2018 provides greater clarity and predictability regarding ownership percentages and dilution.
- Flexible Conversion Terms: SAFEs can convert into equity based on valuation caps, discount rates, or a combination of both, allowing investors to benefit from favorable terms and startups to defer valuation decisions.
- No Debt-Like Obligations: Unlike convertible notes, SAFEs do not accrue interest or have maturity dates, reducing the financial burden on startups and allowing them to focus on growth without immediate repayment pressures.
- High Risk: SAFE agreements do not provide any rights to investors. It is effectively a bet that a company will be more valuable in the future. As with any investment in early-stage companies, there is a risk for a complete loss of principal.
What is a SAFE?
A SAFE (Simple Agreement for Future Equity) is a financial framework used by startups to raise capital. It is an agreement between an investor and a company that provides the investor with the right to receive equity in the company at a future date.
The conversion into equity is usually triggered by specific events such as a future equity financing round (e.g. Series B) or a liquidity event (e.g. IPO, acquisition). The specific price per share is not determined at the time of the initial investment, which makes these very different from traditional equity investments.
These agreements were introduced by Y Combinator in 2013. The goal was to provide early-stage companies with a simpler and more founder-friendly way of raising funds. At the time fundraising was dominated by convertible notes.
Key Characteristics Of SAFEs
- No Maturity Date: Unlike convertible notes, SAFEs do not have a fixed expiration date. They remain outstanding until a triggering event occurs.
- No Interest Accrual: SAFEs do not accrue interest, which means that there is no debt-like obligation for the company to pay interest to the investors.
- Triggering Events: Conversion to equity occurs at predetermined events, such as:
- Future equity financing rounds (e.g., Series A).
- Sale or acquisition of the company.
- Initial Public Offering (IPO).
These features make using a Simple Agreement for Future Equity an attractive option for both startups and investors looking for a straightforward and efficient means of raising and providing early-stage capital.
Due to its simplicity, Simple Agreement for Future Equity is the most common type of investment available on platforms like StartEngine and Wefunder.
How SAFEs Work
SAFE Conversion Mechanisms
SAFEs convert into equity when specific triggering events occur. The terms of conversion are usually defined by either a valuation cap, a discount rate, or a combination of both.
- Valuation Cap: This sets the maximum company valuation at which the SAFE will convert into equity. If the company’s valuation at the next funding round exceeds this cap, the SAFE will convert at the capped valuation, providing a benefit to early investors.
- Discount Rate: This provides a percentage discount on the share price during the next funding round. For example, if the discount rate is 20%, SAFE holders will convert their investment at a price 20% lower than the price paid by new investors in the next round.
Types of SAFEs
There are several types of SAFEs, each with different conversion terms:
- Valuation Cap, No Discount: Sets a maximum valuation for conversion but does not provide a discount on the share price.
- Discount, No Valuation Cap: Provides a discount on the share price but does not cap the valuation.
- Valuation Cap and Discount: Offers both a valuation cap and a discount, allowing investors to choose the most favorable terms at the time of conversion.
- Most Favored Nation (MFN), No Valuation Cap, No Discount: Ensures that investors receive terms that are as favorable as those given to any other investors in the next funding round.
Each type of agreement can be more or less investor friendly. For example, “uncapped” SAFEs can provide less potential reward for an earlier, riskier investment.
Process Overview
The process of using SAFEs involves a few key steps:
- Investment: Investors provide funding to the startup at the time the SAFE is signed. This funding helps the startup grow and reach its next stage.
- Conversion: The SAFE converts into equity during a future funding round or a liquidity event. The conversion terms are based on the valuation cap and discount rate.
- Equity Allocation: The amount of equity that investors receive is determined at the time of the triggering event, based on the pre-agreed terms.
For example:
- A startup raises money using a SAFE with:
- A $100 million valuation cap and a 20% discount
- The next funding round values the company at $150 million
- The SAFE will convert at the $100 million cap.
- Investors will get shares as if the company were valued at $100 million, giving them more equity for their investment.
SAFEs provide a flexible and efficient way for startups to raise capital without the complexities and costs associated with traditional equity financing. They also offer investors the potential for favorable terms and a simplified investment process.
Understanding Post-Money Valuation SAFEs
In 2018 Y Combinator updated the SAFE agreements. The 2018 version is based on a post-money valuation. In other words, the valuation cap includes whatever funds are being raised from investors.
What is Post-Money Valuation?
- Definition: Post-money valuation refers to the valuation of a company immediately after an investment has been made. It includes the pre-money valuation plus the new capital injected by the investment.
- Importance: This valuation method helps both startups and investors understand the precise ownership stakes after the funding round.
Advantages of Post-Money Agreements
- Transparency: Founders and investors can immediately see the impact of the investment on ownership percentages, making it easier to understand the dilution effect.
- Predictability: By providing a clearer picture of dilution, post-money SAFEs help startups plan more effectively for future fundraising rounds.
Example of Post-Money Calculation
- Scenario: A startup has a pre-money valuation of $5 million and raises $1 million through a post-money SAFE.
- Calculation:
- Pre-Money Valuation: $5 million
- Investment: $1 million
- Post-Money Valuation: $5 million + $1 million = $6 million
- Ownership Percentage: The investor’s $1 million investment represents 1/6 of the company, or approximately 16.67%.
Benefits of SAFEs for Investors
Simplified Investment Process
- Faster Transactions: SAFEs streamline the fundraising process by reducing the amount of negotiation required compared to traditional equity financing. This allows investors to commit funds quickly, helping startups to secure necessary capital without lengthy delays.
- Lower Legal Costs: The standardized documentation minimizes the need for extensive legal review, significantly reducing the legal fees for both investors and startups.
- Increased Deal Flow: The simplicity of fundraising means more companies can easily seek financing from investors. This helps to increase investment opportunities.
Potential for Favorable Terms
- Early Investment Rewards: Investors can benefit from favorable conversion terms, such as valuation caps and discount rates, which can provide a larger equity stake if the company performs well.
- Flexibility: SAFEs offer terms that can be tailored to each investment, allowing investors to choose between valuation caps and discount rates to optimize their return on investment.
Benefits of SAFEs for Startups
Efficient Fundraising
- Quick Capital: Startups can raise funds more rapidly compared to traditional equity rounds. This is crucial for early-stage companies that need to move quickly to capitalize on growth opportunities.
- No Immediate Equity Issuance: By delaying the issuance of equity until a later date, startups can avoid the need to set a valuation when their future prospects are still highly uncertain. This can prevent the undervaluation of the company.
Founder-Friendly Terms
- No Debt Obligations: SAFEs are not debt instruments, meaning startups are not burdened with interest payments or repayment obligations. This allows founders to focus on growing the business without the pressure of servicing debt.
- High-Resolution Fundraising: SAFEs enable startups to close deals with investors on an individual basis, rather than coordinating a single round with multiple investors. This flexibility allows startups to secure funding as soon as each investor is ready, rather than waiting for all investors to align.
Risks and Considerations of SAFEs
For Investors
- No Immediate Equity Stake: SAFEs do not confer any ownership or voting rights until they convert to equity. Investors may have less influence over company decisions compared to traditional equity holders.
- Potential for Total Loss: If the triggering events (such as a new funding round or liquidity event) do not occur, investors may never receive equity and could lose their entire investment.
- Uncertain Rewards: The future of early-stage companies is highly uncertain. Even if the company is successful, it may not be able to greatly exceed the valuation caps. This could mean that early investors receive limited additional rewards for the extra risk they took.
For Startups
- Dilution Risk: Significant equity dilution can occur during conversions, especially if multiple SAFEs are issued. Founders need to carefully manage the number and terms of the agreements to avoid excessive dilution.
- Overvaluation Concerns: Postponing valuation until a later funding round can lead to overvaluation. This can make it difficult to raise additional funds at an attractive valuation in the future.
By understanding both the benefits and risks of SAFEs, investors and startups can make informed decisions about using this financing instrument to support their growth and investment strategies.
Comparison with Other Financing Instruments
SAFEs vs. Convertible Notes
- Convertible Notes: These are short-term debt instruments that convert to equity upon a specific event, such as a subsequent financing round. They accrue interest and have a maturity date, creating a debt obligation for the startup.
- SAFEs: These are not debt instruments and do not accrue interest or have a maturity date. This makes them simpler and less burdensome for startups, as there is no pressure to repay or convert by a specific date.
Key Differences:
- Maturity Date: Convertible notes have a set maturity date, while SAFEs do not.
- Interest Accrual: Convertible notes accrue interest, adding to the financial burden on the startup, whereas SAFEs do not.
- Conversion: Both instruments convert to equity, but the terms and triggers for conversion differ, with SAFEs generally offering more flexibility and simplicity.
SAFEs vs. Equity Financing
- Equity Financing: Involves selling shares of the company to investors at a set valuation. This process requires extensive negotiation and legal work to determine the company’s valuation and the terms of the investment.
- SAFEs: Allow startups to raise funds without immediately issuing shares or setting a valuation. This defers the valuation process to a future event, simplifying the initial fundraising process.
Key Differences:
- Immediate Equity Issuance: Equity financing results in the immediate issuance of shares, while SAFEs defer this until a later date.
- Valuation: Equity financing requires an immediate valuation of the company, which can be challenging for early-stage startups. SAFEs postpone this valuation until a triggering event.
- Complexity and Cost: Equity financing involves more complex negotiations and higher legal costs compared to the streamlined process of SAFEs.
Legal and Regulatory Considerations
Securities Laws Compliance
- Registration Requirements: Shares issued upon SAFE conversion are considered securities and must comply with federal and state securities laws. This typically involves filing necessary documents with regulatory bodies, such as the U.S. Securities and Exchange Commission (SEC).
- Qualified Small Business Stock (QSBS): The holding period for QSBS tax benefits begins upon the issuance of stock, not the signing of the SAFE. This timing can affect investors’ eligibility for significant tax advantages.
Investor Protections
- Limited Rights: Before conversion, SAFE holders do not have the rights typically associated with equity holders, such as voting rights or dividends.
- Pro Rata Rights: Some SAFEs include pro rata rights, allowing investors to maintain their ownership percentage in future funding rounds by purchasing additional shares.
Notable Examples: Y Combinator Startups
- Early Adoption: Simple Agreement for Future Equity was introduced by Y Combinator and has been widely used by its portfolio companies. Almost all Y Combinator startups utilize this framework for their early-stage fundraising.
- Global Reach: Beyond Y Combinator, SAFEs have gained popularity among startups and investors in various countries, including the U.S., Canada, and Israel, due to their simplicity and efficiency.
Conclusion
SAFEs provide a flexible and straightforward method for early-stage startup investment. They allow startups to raise capital quickly without the complexities of traditional equity financing and offer investors the potential for favorable terms upon conversion.
While this financing framework can offer significant advantages in terms of simplicity and speed, both startups and investors must carefully consider potential dilution, legal implications, and the timing of conversion events.
Additionally, it is important for investors to remember that SAFEs are very risky investments:
- The entire principal investment can be lost and often will be.
- The agreements provide uncertain future returns with unclear timing. That’s true even in the case where the company performs well and is able to raise future funding.
- Lastly, even if they do convert to equity, that investment is still completely at risk. Until a liquidity event occurs, such as an IPO, any gains are just “on paper.”
Simple Agreements for Future Equity are one of the building blocks of the current startup ecosystem. They are not going away anytime soon, so it’s important for investors to become familiar with them.
