What's a SAFE? Is it Safe?
The SAFE (Simple Agreement for Future Equity) has become increasingly popular since it was introduced in 2013 by Y Combinator, the golden child of tech incubators. But what exactly IS it? Does it work? Is it safe?
The SAFE is an investment contract designed to help facilitate early-stage financing which might otherwise be too complicated or costly. The title of the SAFE steals the punchline for what it does: it's a user-friendly agreement that grants investors rights to future equity of the subject company. At the time the SAFE was first introduced in 2013, early-stage funding prior to a venture capital (VC) financing round was often raised through convertible notes, the older (stodgier) cousin of the SAFE. Since its introduction, the SAFE has been gaining popularity as an alternative to convertible notes.
SAFEs vs. Convertible Note
Like a lot of cousins, the SAFE and the convertible note have similarities. Both instruments grant the investor a right to equity rather than actual shares, both are triggered on a future priced equity round of a certain size, parties don't need to peg a valuation for the Company at the time of issuance (often a tricky endeavor for even the most sophisticated investor), and both documents are streamlined to avoid negotiation over the dozens of finer points of a preferred stock financing that need to be addressed in a full VC round.
However, SAFEs have some founder-friendly distinctions from convertible notes. For one, the SAFE is not debt, so the Company doesn't need to carry debt on the books, and the SAFE typically does not accrue interest. For startups that find themselves chasing their first institutional round for months or even years longer than planned (a common occurrence), 7-8% interest adds up quickly.
How the SAFE works
SAFE with Valuation Cap
Similar to convertible debt, the SAFE can include a valuation cap and/or a pricing discount to give early investors a discounted share price in a later VC funding round. Valuation caps set a maximum conversion price. With the "post-money SAFE", which has been gaining popularity, that SAFE holder ownership is measured after (post) all the SAFE money is accounted for but still before the new money in the priced round that converts and dilutes the SAFE. This assures the SAFE holder that he/she will have a set amount of ownership regardless of how much is raised in the SAFE round.
- Josephine invests $100,000 in AceCo using a post-money SAFE with no discount but a $2,000,000 cap.
- 12 months later, AceCo raises $2,000,000 in a Series A priced round
- Assume a Series A price of $1.00 per share, representing a $5mm pre-money valuation
Regardless of whether AceCo raises just $100k in SAFEs or $500k or $1mm, at the closing of the Series A, assuming no other fundraising aside from the SAFE in between, Josephine is entitled to 5% of the Company ($100k/$2mm cap) immediately prior to the Series A closing. That implies 250,000 shares owned by Josephine immediately prior to closing instead of the 100,000 shares she would be entitled to if she were investing $100k straight into the Series A round as a new investor.
SAFE with Pricing Discount
A pricing discount gives the SAFE holder a percentage off of the valuation price in the future equity round.
- Joe invests $100,000 in AceCo using a SAFE with a 20% discount.
- 8 months later, AceCo raises $2,000,000 in a Series A
- Assume a Series A price of $1.00 per share
At closing of the Series A, Joe's $100,000 entitles him to purchase 125,000 shares of Series A (rather than 100,000 shares if he were a new investor).
The SAFE is a simple and effective agreement to facilitate early investments with low friction. Despite the ease of use of the SAFE, however, entrepreneurs should be sure they fully understand the mechanics and implications of issuing SAFEs. It is important to model what the cap table will look like before and after the future priced equity round. If, for example, during the future equity round the company is valued at an amount lower than the valuation cap, SAFE holders may be entitled to purchase a larger percentage ownership of the company than anticipated. Also, while SAFEs can be used in early investment transactions, they are not well suited for getting equity into the hands of service providers. Like any equity transaction, founders should approach the SAFE cautiously and follow appropriate corporate governance processes with a close eye on the cap table before raising any money using a SAFE. And as always, founders should seek accounting and legal advice if they have questions about the process or consequences of an equity transaction.
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