In a bid to scale their business ideas and operations, startups require funding at different times. There are typically five stages of funding required for a startup to become an established business. They are Seed Funding, Angel Investment Funding, Venture Capital Financing, Mezzanine Financing and Initial Public Offering (IPO). SAFE agreements are financing contracts that may be used by a startup company to raise capital in its seed financing rounds.
A SAFE agreement has evolved to become one of the main instruments for early-stage funding. A SAFE (simple agreement for future equity) is an agreement/contract between an investor and a company that gives the investor the right to receive potential equity of the company on certain triggering events, such as an additional round of financing or the sale of the company. A SAFE agreement provides potential equity to an investor in exchange for immediate cash to the company. The shares to be given to the investor are not valued at the time the SAFE is signed and actual valuation of the shares is deferred until the advent of the triggering events as outlined in the SAFE agreement. Unlike a convertible note, which is also one of the ways through which startups raise seed capital, a SAFE is not a loan; it is more like a warrant. In a SAFE agreement, no interest is paid, and a maturity date more often than not does not exist. Until the happening of a conversion event outlined in the agreement, such as an additional round of financing or the sale of the company, a SAFE remains outstanding.
A SAFE is similar to a convertible note as both instruments provide potential equity to an investor. However, unlike a convertible note, a SAFE is not a debt instrument. A SAFE is relatively easy to create and implement, does not accrue interest as a loan does; and offers flexibility in the way a company raises funds. There could be situations where the triggering events as defined in the SAFE agreement aren’t activated. In such situations, the SAFE will not be converted. For instance, if a company in which you invested makes enough money that it never again needs to raise capital, and it’s not acquired by another company, then the conversion of the SAFE may never be triggered.
The four types of SAFE notes include:
- A valuation cap, but no discount
- A discount, but no valuation cap
- A valuation cap and a discount
- No valuation cap and no discount
What are the benefits of SAFE agreements to startup companies ?
- Control : Without the repayment obligations and maturity dates looming over the startup, and so founders have more freedom and flexibility and good time to ensure that their vision and dreams materialize as intended.
- Simplicity : Since SAFEs are so simple, there are fewer terms to negotiate, making everything that needs to be discussed clear and concise. In fact, the only things that really need to be negotiated are the discount rate and the valuation cap.
- Ease of entry and startup’s comfort: As an early stage investor, a SAFE note is an easy way to invest in a company post the without the paperwork and effort of a convertible note. Also, convertible notes usually come with obligations that might hamper future investment from other parties (e.g., interest payments, investor subordination [debt gets paid before equity], etc.).
- Accounting: Like other convertible securities, SAFE notes end up on a company’s capitalization table.
- Conversion to equity: Investors can change their investment to equity later. The date of conversion is not predetermined, but it can happen when an equity round is raised and preferred shares are distributed.
Challenges of SAFE agreements
- Risks to investors: SAFE notes are not an official debt instrument. This means there is a chance they will never convert to equity and that repayment is not required.
- Incorporation requirement : A company must be incorporated for it to offer SAFE notes.
- Distribution of dividends: Dividends are not to be paid to SAFE note holders the way they are paid to common shareholders.
- Lower returns: Accruing no interest on a short-term investment is not a big deal. However, if you hold an investment for over a year, it could make a huge difference. Accrued interest gives note holders a greater return on their investment and creates an incentive for a company to close an equity round.
- No minimum requirement: With SAFEs, there is no minimum requirement for an equity round to go into conversion. However, a minimum can actually be helpful because it lends the round legitimacy and value. It means that a SAFE note can be re-adjusted on a whim and that a smaller investor can negotiate a better deal and compete.