SAFE stands for Simple Agreement for Future Equity (SAFE). It is an agreement between the company and the investors under which the investors receive a future stake in the company when a pre-specified conversion event occurs.
History of the SAFE
The SAFE was first introduced by Y Combinator’s Legal Dream Team in late 2013 as an alternative instrument for startups to raise funds. It worked as warrants to ensure a simple, easy, and fast means to raise funds. Investors get to invest in an early-stage company and get a future stake in the company on conversion. The conversion event may be a future round of funding, IPO or acquisition.
When introduced, the pricing of SAFEs was done pre-money. However, after several changes in the equity crowdfunding industry, the calculation of a SAFE’s conversion is now done post-money, i.e. the ownership of the SAFE holders is measured after the SAFE money is taken into account.
One platform that often uses the SAFE is Republic. If you want to learn more about their specific SAFE, check out this piece written by legal counsel, Max Rich.
What is the purpose of a SAFE in crowdfunding?
The SAFE has become one of the most common instruments for raising funds in equity crowdfunding. When it began in 2013, the SAFE was the method to get the first money into the company and has been expanded to be utilized in seed rounds as well.
Many startups and investors are opting for SAFEs as they are simple and therefore quick to implement for a fundraising round. A SAFE is a one-document, uncomplicated instrument, without hundreds of terms to negotiate. This makes it easier for both investors and companies to work with SAFEs. The only points to be negotiated are the valuation cap and discount rate. The intent behind SAFEs is to remain fair to both investors and entrepreneurs.
In addition, a SAFE offers high-resolution fundraising, which means that the company can close the deal with an individual investor as soon as they are ready. The deal does not need to be closed with all investors simultaneously.
The SAFE agreement specifies the valuation cap for the conversion of the SAFEs to equity to prevent dilution. It also offers discounts to SAFE investors for purchasing the common stock of the company at later stages.
There are terms and conditions for the conversion of a SAFE into a future equity stake in the company on the occurrence of the conversion event. The terms also include information regarding what will happen if the startup fails and the company gets liquidated.
How is a SAFE different from other financial instruments?
At times, SAFEs may be confused with convertible notes. However, both the instruments do vary. Convertible debt consists of money that investors loan to the company and get interest payments on (though technically this rarely, if ever, actually occurs). On the other hand, a SAFE is not a loan, and the investors do not receive interest payments.
Convertible notes have maturity dates whereas SAFEs do not. Therefore, there are more negotiations involved in working out convertible notes when used as the investment instrument. As compared to the other instruments as well, like loans or equity, a SAFE is less complicated and less time-consuming.
What are the Pros of SAFEs?
The SAFE has numerous benefits over conventional instruments for raising funds. Some of the most significant advantages of SAFEs are:
- Simplicity: The most important advantage of a SAFE is its simplicity. The agreement documents are short and concise, as opposed to the intricate and lengthy documents associated with the other modes of raising funds. They do not have a maturity date or an interest rate, so there is little to be explained or negotiated.
- Less cost and time: Due to the simplicity associated with SAFEs, they typically take less time to close. Funds can be raised by the entrepreneurs when needed, without spending a lot of time on the legal details.
- Founder friendly: Since SAFE agreements don’t have a maturity dates, the founders are not under any pressure to work out a financing deal in a limited time frame that may not be best for the company. Founders also do not need to pay interest on SAFEs and are not under insolvency threats from debt holders.
What are the Drawbacks of SAFEs?
Many people have strong opinions around SAFEs and there is validity to that. Below are some of the drawbacks.
- Valuation cap: In some SAFE agreements, the pre-money and post-money valuation cap are not specified. Due to ambiguity and uncertainty, many investors face much more dilution than they signed up for when investing in uncapped SAFEs. Small SAFE rounds can have an unprecedented impact on the future valuation of the company and cause dilution implications.
- Financial viability of the company: Not only is this arrangement potentially harmful to the investors, but also for the entrepreneurs. If the founders issue multiple SAFEs at different valuation caps, it impacts the capitalization table of the company and can impact the financial viability of the company negatively.
- Lack of concrete terms: It has been observed that SAFE agreements are uncomplicated with very few terms to negotiate; however, the same turns out to be a double-edged sword at times. Due to the lack of concrete terms, such agreements can create tension between the investors and founders, especially at the times of conversion.
Thus, a SAFE is a unique, innovative, and simple instrument for raising funds. However, investors and founders need to be vigilant and careful while entering into SAFE agreements to ensure that the investment and the funding do not turn out to be awry and complicated at the later stages.
Be sure to consider all of these aspects when considering an investment that utilizes a SAFE.