A Simple Agreement for Future Equity (SAFE) is a financial instrument introduced in 2013, gaining significant popularity within the startup ecosystem, especially among early-stage companies due to their simplicity, flexibility, and founder-friendliness. Startups often struggle with accurate and fair valuations in their early stages, and SAFEs let them postpone this challenge until a later funding round, usually when more information is available to determine the company's worth.
In this article, we will explore everything you need to know about SAFE agreements, including their benefits and risks, and how they compare to other investment instruments.
A SAFE (Simple Agreement for Future Equity) is a contract between a startup and investors that allows the company to raise capital without immediately determining a valuation or issuing equity shares. SAFEs are an innovative investment tool designed to provide startups with funding flexibility, especially during the early seed stage when valuations can be difficult to establish.
It exchanges the investor's investment for the right to preferred shares in the startup company when a triggering event occurs, such as an acquisition, IPO, or subsequent funding round. The SAFE agreement outlines the specific terms and guidelines that will govern how and when the invested capital will be converted into company equity shares. In contrast to a convertible note, a SAFE does not accumulate interest over time nor have a set expiration date by which the note must be repaid or converted.
Y Combinator, a renowned startup accelerator, initially proposed the concept of SAFEs and continues to influence their development today.
SAFE agreements work by providing investors with the right to convert their investment into equity at a future date when a triggering event occurs. The triggering event is typically a priced equity financing round, an acquisition, or an IPO.
The conversion price is determined by the terms of the SAFE agreement, which can be negotiated between the startup and the investor. The conversion price is usually set at a discount to the price per share in the subsequent financing round, which rewards early investors for taking on more risk.
A SAFE agreement includes 4 important aspects:
1. Valuation Cap: This sets the maximum valuation level at which SAFE investments will convert to equity shares, even if the actual company valuation surpasses this cap amount. This allows SAFE investors to receive a larger equity stake the higher the company's valuation rises over time.
2. Discount: A discounted share price may be applied if the SAFE converts when the valuation is at or below the cap. This lets investors purchase shares at a reduced valuation compared to other investors.
3. Pro-Rata Rights: Gives investors the ability to increase their investment to maintain the same percentage ownership after future funding rounds.
4. Most-Favored Nation Provision (MFN): Requires the startup to offer the same preferential terms to all SAFE investors. If better terms are offered to new investors, previous SAFE holders must also receive those advantageous conditions.
Y Combinator has come out with 4 types of the Simple Agreement for Future Equity (SAFE), which are:
1. SAFE: Valuation cap, no discount
2. SAFE: Discount, no valuation cap
3. SAFE: Valuation cap and discount
4. SAFE: MFN, No valuation cap, no discount
A hypothetical example of a SAFE agreement is as follows: A startup raises $500,000 from an investor through a SAFE agreement. The SAFE agreement provides that the investor has the right to convert their investment into preferred shares at a 20% discount to the price per share in the subsequent financing round.
The startup subsequently raises $1 million in a priced equity financing round at a price per share of $1. The investor can convert their investment into preferred shares at a price per share of $0.80, which is a 20% discount to the price per share in the subsequent financing round.
The benefits and risks of SAFE Agreement are:
1. Not Debt: SAFE agreements do not accrue interest and do not create debt on the company's balance sheet. SAFEs have no repayment obligations or set timelines, giving startups flexibility if they fail and with converting funding to equity.
2. Standardized and Easy to Issue: SAFE agreements are typically standardized and easy to issue, requiring less negotiation and paperwork than issuing shares directly.
3. More Founder-Friendly: Considered more founder-friendly because they provide more flexibility and don’t impose a maturity date like convertible notes.
4. Faster and More Affordable: SAFEs could be faster and more affordable than a priced round, as there are fewer terms to discuss and negotiate.
5. No Interest Rates: As a founder, you don’t have to worry about paying down debt with a SAFE.
1. High Risk: SAFE agreements are high risk as they don’t convert to equity unless a liquidity event occurs.
2. Uncertainty for Future Valuations: The unknown future valuation creates uncertainty around SAFE conversion prices.
3. Limited Investor Rights: SAFE investors have limited control over company decisions compared to traditional equity investors.
4. More Difficult to Find Investors: Due to their unique structure, you may have to search harder for investors willing to bet on your company early.
5. Lack of Investor-Friendly Terms: Convertible notes tend to be more investor-friendly because of the maturity date, which imposes more investor-friendly terms.
SAFE Agreement vs Convertible Notes
SAFE agreements are classified as equity, not debt, because they do not accrue interest or have a maturity date. They are a contractual promise between investors and startups to exchange capital for the right to preferred shares in the future.
In conclusion, the Simple Agreement for Future Equity (SAFE) serves as a vital tool for early-stage startups looking to raise capital efficiently and flexibly. With its simplicity and lack of debt characteristics, SAFEs enable startups to navigate the challenges of fundraising while minimizing risks and costs.
However, it's essential to recognize that SAFEs come with their own set of complexities and nuances. Both startups and investors should thoroughly understand the terms involved, seek professional advice, and engage in open communication to achieve mutually beneficial outcomes.
As SAFEs continue to evolve and adapt to the ever-changing landscape of entrepreneurship, it remains critical for those working within the startup ecosystem to stay informed.
