What is a SAFE and why should I use it to start funding my startup?

May 1, 2018

By Pam Lambert

What is a SAFE?

The Simple Agreement for Future Equity, commonly known as a “SAFE” was created by Y Combinator as an alternative to the convertible promissory note. Essentially, a SAFE is a promise by a company to issue equity in that company to a SAFE investor on the occurrence of a specific future event (usually the next priced equity financing), in exchange for the SAFE investor’s cash now.

Why should I use a SAFE to raise money for my startup?

After formation, most startups need money quickly to develop their ideas and fund general operations. Traditionally, an early-stage startup would either conduct an early preferred equity round (series seed or series a) or issue convertible promissory notes. These traditional funding options have several drawbacks for startup companies. Preferred equity rounds force the founder to set a valuation for their very early stage company, which often leads to founders issuing equity at a lower valuation than if they waited until the company was more established, thus giving away a larger piece of their company. Additionally, preferred equity rounds are expensive for very early stage companies because multiple legal documents and complex terms are drafted and negotiated. Convertible promissory notes are debt, and as such, have interest rates, maturity dates, are subject to certain regulations, and may be secured by the company’s assets.  If the maturity date of the convertible promissory note is reached before conversion, the company must, pay back the debt with interest, or convert the debt into equity, or negotiate with the investor to extend the maturity date often leading to less favorable terms for the company. Y Combinator created the SAFE to avoid these issues.

Unlike a preferred equity financing, the SAFE is a one-document security with limited negotiated terms (which are discussed below) and generally avoids the founder having to set a valuation for their early stage startup. This saves the company and the investors a lot of time and money, which everyone loves. Unlike convertible promissory notes, a SAFE does not have a maturity date and does not accumulate interest. SAFEs remain outstanding indefinitely until a conversion event or upon dissolution or winding-up of the company. The lack of a maturity date helps companies avoid the threat of noteholders bankrupting the company should they demand repayment of their notes at maturity. While SAFEs do not accumulate interest, they generally receive a discount on the next priced equity financing, either based on a discount on the price per share, or based on the valuation cap (which are explained below). Overall, SAFEs are considered to be a company-friendly investment vehicle and are widely used by early-stage startups who are looking to raise money before their company is ready to do a traditional priced equity round.

Why would an Investor invest through a SAFE?

As mentioned above, because the SAFE investor is risking her investment when there is more uncertainty surrounding the company, SAFEs have some key benefits for investors (otherwise the investor would just wait until the priced equity financing takes place). These key features can include, a valuation cap, a discount rate, and “pro-rata” rights, or a combination thereof.

The Valuation Cap – This is a common feature in both SAFEs and convertible promissory notes. The valuation cap sets the maximum pre-money valuation that the SAFEs will convert at in the company’s next equity financing. The valuation cap ensures that the SAFE investors, who took on more risk than the later equity investors, still receive a meaningful stake in the company should the next equity financing pre-money valuation be unusually high. The company must be very careful about setting their valuation cap. If the valuation cap is set too low, the SAFE investors will get a significant windfall, potentially so large, that the later equity investors will force the company to renegotiate with the SAFE investors before they invest to avoid dilution from the SAFE’s low valuation cap.

The Discount – This is another common feature in both SAFEs and convertible promissory notes. The discount means the SAFE investors pay less than the later equity investors for the same equity security. The discount rates generally range anywhere from 5% to 30% off the next equity security price, with a 20% discount being the current most common rate. Most SAFEs and convertible promissory notes will give the holder the better deal (meaning the lower price) between the valuation cap and the discount to ensure the early stage investors receive a sufficient stake in the company for taking on additional risk.

Pro Rata Rights – Some SAFEs and convertible promissory notes will grant some or all of the early stage investors pro rata rights. Pro rata rights, also known as preemptive rights or a right of first offer, grant the investor the right to purchase new securities in the company when the company offers them (subject to certain customary exceptions). It is common to grant these rights to investors who have invested significant amounts of money in the company relative to other investors. Generally, it is not recommended to offer these rights to all investors to avoid having to approach every small investor each time the company wants to raise more money.

Other Key Issues to Consider

While SAFEs were created for their simplicity, there are several other issues that founders and the company need to think about, including the liquidation preference of the SAFEs or convertible promissory notes when they convert into equity securities. As mentioned above, the difference between the valuation cap and the actual pre-money valuation of the next equity financing has significant implications (which is why it is so important to carefully consider what the valuation cap should be).

Liquidation Preference – In a priced equity financing, the investors generally receive at least their money back (sometimes a multiple of their investment) before the common stockholders. However, because SAFE and convertible note investors are receiving a discount on the equity (either through the discount rate or the valuation cap), the SAFE and convertible note investors actually receive a greater liquidation preference than the equity investors who paid “full price” for their equity. If the discount and valuation cap are reasonable, the amounts at issue tend to be relatively insignificant, unless the discount rate is too large, or the valuation cap is significantly lower than the actual pre-money valuation. To avoid this issue, some companies will create a “shadow” series of preferred stock that is identical to the preferred stock issued in the priced equity round with the exception of the liquidation preference, which is set at the actual dollar amount invested by the SAFE or convertible noteholders. Now this becomes more complicated and less practical if the company issued SAFEs or convertible notes with varying discount rates and valuation caps.

Should I raise money via a SAFE and how I do I set the terms?

As SAFE financings become commonplace in startup communities, and in this day and age of widely available open source legal documents, founders and executives often find themselves stumbling over many of the issues discussed in this article. It is important for founders and executives to discuss their fundraising efforts with experienced startup legal counsel. Experienced startup legal counsel understand that startups and early stage companies cannot afford significant legal fees and will work with founders and executives to utilize the vast open source legal resources available to keep fees down while guiding the company to make the best decisions for their situations.

2018-07-27T17:17:30+00:00July 27th, 2018|
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