A Guide to Simple Agreements for Future Equity (SAFEs)
By Shreya Kalidindi, for Legal Corner LLP. Shreya is a fourth-year student of NALSAR University of Law and will be graduating in 2022.
The views expressed here are not to be considered as legal opinion. You may not rely on this article as legal advice. You should reach out to me (chetana@legalcornerllp.com) if you are seeking advice on structuring SAFEs or other investment agreements tailored to your business needs.
What are SAFEs?
A Simple Agreement for Future Equity (SAFE) agreement is one made between a company (generally in its seed financing round) and an investor wherein the company agrees to provide an investor with potential future equity in return for immediate cash. They have been introduced by American startup accelerator Y Combinator in 2013 and have since gained popularity among both founders and investors, mostly owing to their simplicity.
How do SAFEs convert?
The future equity – or the SAFE – eventually converts to equity during a subsequent round of financing, provided that a particular trigger event (previously agreed upon and outlined in the SAFE Agreement) takes place. Trigger events can include subsequent rounds of equity financing, the sale of a majority of the company’s shares, or the acquisition of the company. The size of equity investment is not material.
Following the trigger event, the investor has a choice between receiving the investment amount back or converting it into shares in the company. The number of shares receivable upon such conversion depends on where the share price stands during either the priced equity round or the trigger event (as applicable). Prior to the SAFE maturing in this manner, it is treated like any other convertible security (for instance, options or warrants).
How do SAFEs differ from Convertible Notes?
The primary difference between the two is that Convertible Notes have a maturity date, upon which the amount given by the investor is either converted into equity at a predetermined rate or is returned. Furthermore, investments under Convertible Notes are considered to be loans, and involve more negotiation than SAFEs, seeing as the notes convert after a specific period, and can accrue interest during this period.
What makes SAFEs a distinctive form of raising funds?
Maturity – SAFEs do not have an expiry date. They remain valid and continue to exist in the issued state until a trigger/ liquidation event occurs, upon which they convert into shares.
Interest – A SAFE is not a debt instrument, and thus a SAFE investment does not accrue interest, regardless of how long it takes for it to convert into shares.
Deferred Valuation – Similar to other forms of convertible debt, there is no requirement for the company and its investors to agree upon a valuation price at the time of entering into the SAFE Agreement. This can be ascertained at a later date and is usually done when the company has more revenue.
Why are startups opting for SAFEs?
In the previous year, the number of SAFEs and other similar notes (such as the Keep It Simple Securities, also known as KISS) that have been used by pre-funding companies was 58%, thus making them equally prevalent as convertible notes. This is largely owing to the fact that they are seen as a simple and risk-free method of raising money.
SAFEs terms are not standardized to a large extent, and thus can be negotiated – often to the benefit of the startup. These include terms relating to conversion, dissolution and repurchase rights. Furthermore, seeing as SAFEs only conditionally convert into shares on a later date, voting rights are not immediately given to the investors. This enables many startups to retain a larger degree of control during their initial stages and inculcate practices that help materialize their vision.
Apart from the benefits of flexibility and control, SAFEs are also preferred because their implementation involves a lesser degree of paperwork and legal costs.
Important terms to be established in a SAFE agreement
Valuation Cap – this is the maximum valuation at which a SAFE can convert to equity upon maturing. For instance, if the valuation cap is $6 Million and the company raises money at a valuation of $10 Million, then the investor is entitled to convert their SAFE at a share price equivalent to the former amount.
Discount – this is the valuation discount given to a SAFE investor and is relative to the investors in the subsequent financing round. These discounts range between 10% to 30%, and are usually implemented to entice early investors. For instance, a SAFE is issued with a 20% discount, and the investor puts in $60,000. If the future investment is $15, the price per share after discount will be $12. Thus owing to the discount, the investor ends up with 5,000 shares instead of 4,000 shares.
A SAFE can come with either of these provisions, both of them, or a Most Favored Nation (MFN) clause instead of the discount or valuation cap.
Risks associated with issuing SAFEs
While SAFEs offer benefits such as expediency and simplicity, using them as financing options can also be one of the reasons for the failure of an issuing company. One of the largest issues that SAFEs can create for a company is unintended dilution of ownership. Seeing as SAFE dilution is not reflected in the capitalization table till the point of maturity, many issuers may lose sight of how much dilution they are taking on. If due consideration is not taken, issuing SAFEs in such a manner may even lead to a loss of control in the company.
Even before future equity rounds, another risk posed by SAFEs is improper valuation. Often, the valuation cap is seen as the actual valuation of the company, which in turn makes any price below this cap an undesirable ‘down round’ in subsequent priced financing rounds.
Additionally, while one of the advantages of issuing SAFEs is their flexibility, this also allows for the insertion of one-sided and onerous clauses (such as guaranteed board seats) being put in favor of the investor. Such terms make it difficult for investors in future equity rounds to provide funds for the company, seeing as more than the expected degree of company control has been relinquished.
However, these inherent risks can be combatted through measures such as creation of dynamic capitalization tables to track SAFE dilution, putting a hold on company valuation during the SAFE stage, and ensuring that the non-standard terms of a SAFE Agreement are well balanced and negotiated.
If you have any questions on SAFEs, please email me at chetana@legalcornerllp.com . I will be happy to set up a free consultation.