For a startup, access to capital provides an incredibly important key to success: runway. It is the stark reality of the startup world that many startups close because they’ve run out of cash before they can find a product-market fit. Capital provides the breathing room a startup needs to develop an MVP, ensure market fit, or pivot when needed. Bootstrapping is possible if the founders have saved enough and are comfortable funding the venture, but often, cash needs to come from an external source.
The standard external sources of financing come either in the exchange of equity for money or through debt. The former can pose challenges for early-stage companies where adequate valuations are ambiguous at best, and the latter may be unpalatable for a new market entrant that is pre-revenue.
A hybrid approach filled the void between the two financing models, first in the form of convertible notes and later through SAFEs, or Simple Agreement for Future Equity. Y Combinator introduced the SAFE in 2013 as a set of contractual terms that could be simply negotiated and executed quickly, putting money in the founder’s hands in exchange for an amount of equity at some point in the future. This article will discuss convertible instruments generally, but the focus is on the more popular SAFE.
In the eleven years since its introduction, SAFE use has blossomed as a form of startup financing.
Background
At the highest level, the SAFE falls under the umbrella term of convertible instruments. Like its predecessor, the convertible note, it converts (hence the name) the investment into equity upon the occurrence of a predefined event at some point in the future, commonly the next (or first) priced round.
The convertible note was developed to address similar problems the SAFE attempts to solve. Namely, startups sought ways to finance their venture relatively quickly without heading to a bank for a pure debt transaction and when the startup valuation was unclear. While not a strict loan, convertible notes are structured like a loan in that a principal amount is invested, accrues interest over time, and matures at a set date when both principal and interest are due.
Being an investment vehicle framed like a loan, repayment of the note is not really the goal. The intent was never to reach maturity. Both the investor and the startup wanted the note to convert upon an equity financing, whereby the investor would benefit from the investor’s early-stage risk-taking via equity in the company.
The convertible note was not without its drawbacks. Founders sometimes needed to amend their convertible notes when the maturity date was rapidly approaching, and additional funding was not on the horizon. Founders in this position found themselves disadvantaged at the negotiating table. Additionally, convertible notes amounted to a reduction in paperwork compared to a standard loan package, but they still required significant legal drafting. After many years of this hybrid convertible note, the environment was ripe for an alternative.
Enter the SAFE. The SAFE is a legal contract between a startup and an investor that builds upon the concepts first used by the convertible note. Like the note, it is a contract that gives the investor the right to purchase equity in the company at a future date, typically when the startup raises another round of funding or undergoes an acquisition. Unlike the note, the SAFE foregoes the interest rate and the maturity date. This means the SAFE avoids the added interest calculation upon conversion, which streamlines the process and avoids running into the maturity date and all the potential issues with the date.
The key difference between a SAFE and a convertible note is the SAFE structure. The SAFE creates an even more straightforward, efficient contract designed to streamline early-stage fundraising without some of the key pain points of the convertible note.
Key Terms of a SAFE
While several different SAFE documents exist to choose from, nearly all versions will contain the following key terms and concepts. However, some of these concepts may be interchanged depending on the company's and the investor's positions. For example, a SAFE will either be a pre-money or a post-money SAFE, and a SAFE may include a valuation cap, a discount rate, or both.
Valuation Cap
The valuation cap sets the maximum valuation at which the investor's SAFE converts into equity. This term protects investors by ensuring they receive a favorable conversion price even if the company's value has significantly increased by the time of the next funding round. For example, suppose the valuation cap is $5 million, and the company raises a future round at a $10 million valuation. In that case, the SAFE holder will still convert their investment as if the company were valued at $5 million. If a SAFE contains both a valuation cap and a discount rate, the SAFE holder will receive the conversion price that is most favorable to the SAFE holder.
Discount Rate
The discount rate is a percentage reduction on the price per share the investor pays when the SAFE converts during the next equity financing round. A typical discount rate is between 10% and 20%. The discount rewards the investor for taking an early risk by allowing them to buy shares at a lower price than new investors in the priced round.
WORDS OF CAUTION: The terms discount rate and discount are sometimes used interchangeably in informal conversations when discussing SAFEs. They are products of each other in that the discount rate is 100 – the discount (e.g. 10,0-90 = 10%) and the discount is 100 – the discount rate (e.g. 100-10 = 90%). Mistaking one for the other could result in an investor receiving an exceptionally favorable price for their investment.
Post-Money SAFE
In a Post-Money SAFE, the SAFE investor’s ownership is determined after all SAFEs, convertible securities, and other financings have been issued. This clarifies the percentage of the company the SAFE investor will own after the conversion.
Pre-Money SAFE
A Pre-Money SAFE calculates ownership based on the company’s valuation before the new money is raised, which can lead to more uncertainty for the investor. The Post-Money SAFE predominates the startup ecosystem, but in consultation with an attorney, either document can be used for fundraising.
NOTE: A pre-and post-money SAFE with the same valuation cap will result in different ownership levels for the investor. Make sure you understand the impacts and ramifications of the document you use before signing a SAFE.
Liquidity Event
In the YC version of the SAFE, this is either a change in control, a direct listing, or an IPO, and the investor is typically entitled to a return. This could be either a repayment of their initial investment or a conversion into equity immediately before the liquidity event. This differs from a dissolution event, which most likely results in the company winding down and the investor losing their investment.
Conversion Trigger or Equity Financing
The event that triggers the conversion of the SAFE into equity is typically the next round of qualified financing. This provision defines when the investor will receive their equity in the company. It is not based on a fixed timeline but depends on the startup’s future fundraising activities, which may or may not occur.
Pro-Rata Rights
Pro-rata rights allow SAFE investors to participate in future funding rounds, ensuring they can maintain their percentage ownership in the company if they choose. This provision is important for investors who want to avoid dilution. It gives them the right, but not the obligation, to invest additional funds in subsequent financing rounds to maintain their ownership percentage. The YC versions accomplish this via a side letter to the SAFE.
Most Favored Nation (MFN) Clause
An MFN clause allows the SAFE investor to adopt more favorable terms offered to future investors if the company issues SAFEs with better terms (e.g., a lower valuation cap or higher discount rate). This clause protects early investors by ensuring they aren’t left with worse terms than later investors.
Benefits of SAFEs
One of the biggest advantages of SAFEs is that they are simple and fast to execute. SAFE agreements are typically short, standardized documents that don’t require lengthy negotiations or complex legal maneuvers. This simplicity makes it ideal for early-stage startups that want to avoid costly legal fees and time-consuming processes.
Since a SAFE is not intended to act as debt, there are no interest accruals or repayment obligations outside of certain events primarily around dissolution, and even these obligations are usually junior to other obligations. This is highly advantageous for startups that want to preserve their cash flow without worrying about paying back loans. Additionally, there is no maturity date, so there’s no looming deadline for conversion.
A SAFE can provide startups with flexibility by allowing them to defer valuation decisions until a later stage. By setting a valuation cap or discount rate, startups can raise funds quickly without setting a concrete company valuation, which can be difficult at an early stage.
Startups can avoid immediate equity dilution with a SAFE, which allows them to retain more ownership in the early stages of development. This could be critical for founders who want to maintain control of their company until they reach a more stable financial footing, but this can be a double-edged sword.
Risks of SAFEs
Because there is no immediate equity dilution with a SAFE, founders risk overlooking the dilutive effects of SAFEs, especially if the startup has executed a large number of SAFEs on different terms. This could surprise founders if there is significant time between the execution of the SAFEs and the financing round that results in the SAFE's conversion into equity. At that stage, it is likely too late to do anything other than accept the dilution of the founder's share of the company.
Since a SAFE does not have a maturity date or interest accrual, there may be little pressure on the startup to raise another round of funding or reach a liquidity event. For some founders who operate better with set structures and fixed deadlines, the flexible nature of the SAFE could have more of a harmful impact on the startup by removing the maturity date deadline.
As highlighted in the Key Terms above, while SAFEs are simple, misunderstanding or misapplying a few important points can result in a windfall for the investor when the SAFE converts to equity. Confusing the discount rate with the discount or using a post-money versus a pre-money valuation cap can result in the investor receiving different amounts of equity.
Compliance with securities laws is often overlooked. While SAFEs have facilitated access to capital, that capital is exchanged for equity securities, and all founders who sign SAFEs need to understand what is required to ensure compliance with federal and state laws and regulations. This could mean filing a Form D with the SEC, filing similar forms with state regulators, and ensuring that the company investors are accredited.
SAFEs have become commonplace over the decade after their introduction into the startup ecosystem. They can be a valuable tool for startups and investors seeking a simple, flexible way to raise capital. While SAFEs offer several benefits, they should not be used haphazardly.
This article goes into depth regarding SAFE, its terms, and convertible notes in general. Still, hours could be spent discussing the nuances of convertible instruments, and each use should be considered on a case-by-case basis. Startups should work with their legal counsel when seeking and accepting investment, but by understanding the terms and nature of the SAFE, they can make a more informed decision about when and where to apply the document.
This article is for informational purposes only and may not be considered legal advice.
Do you have any questions on using convertible notes to fund your startup? Peak Corporate Counsel’s attorneys are here to guide you through SAFEs, convertible instruments, and other matters with savvy legal advice to your needs. Visit our Website or Contact Us today to schedule a consultation.
Comments