Simple Agreement for Future Equity Safe Investment Vehicle Serving Businesses Throughout Ohio and California

Simple Agreement for Future Equity (SAFE) Investment Vehicle

Startups and emerging companies often have unique, potentially profitable ideas, but without funding, ideas never get off the ground. Financing your business often requires outside funding, and a simple agreement for future equity (SAFE) may be the right choice for you.

What is a Simple Agreement for Future Equity (SAFE)?

SAFEs were first introduced in 2013 by Y Combinator. The goal of SAFEs was to offer an alternative to convertible debt, and due to the SAFE’s low costs and highly standardized terms, it’s now one of the more popular investment vehicles that our clients at Kinetic Law use.

SAFEs are generally used for smaller financing rounds – certainly any round under $1 million, although in some developed startup markets SAFEs may be used for rounds over $1 million.

Convertible notes are debt instruments that convert into preferred equity upon a triggering event, usually a subsequent financing.

SAFEs operate very much the same way as convertible notes but without the debt component. There is no maturity date, and interest does not accrue. In addition, using SAFEs avoids having to put a valuation on the company, which can be very difficult for an early-stage startup.

As with convertible notes, SAFEs have a limited set of variables that determine how much equity the investor will get when the SAFE converts:

Discount rate, and/or
Valuation cap

Early-stage startups need to attract investors, and offering a conversion discount, either through a straight discount or a valuation cap, provides investors with an incentive to invest during the riskier period of a startup’s development.

A SAFE can have a discount rate only, a valuation cap only, or both a discount and a valuation cap. There’s also the option to add a “most favored nation” clause, which means that if you issue subsequent SAFEs on more favorable terms (such as a lower valuation cap), the investor’s SAFE will be “upgraded” to those more favorable terms.

What is a SAFE Valuation Cap?

A valuation cap provides protection for the investor, and it sets a maximum value for equity in the agreement. For example, if the startup has a valuation that is higher than the cap during a funding round, the SAFE will convert at the valuation cap, rather than at the higher valuation set for the funding round. This means that the investor will get more shares than he or she otherwise would. Note a general rule of thumb – a higher valuation cap benefits the founders, while a lower valuation cap benefits the investor by causing more dilution to the founders.

What is a SAFE Discount?

As an alternative, the SAFE could convert at a simple discount. The discount rate is generally 20%. This means that if the price per share of equity issued in a new financing is, for example, $1.00, the SAFE would convert at $0.80. A SAFE investment of $100,000 would convert into 125,000 shares, instead of the 100,000 shares without the discount.

What Happens If the Startup is Acquired or Goes Into an IPO?

Triggering events are the basis of a SAFE, but what happens if the startup never makes it to an equity-financing round? In this case, we’re assuming that the startup is acquired or has an IPO.

In both of these scenarios, the investor has the option to either receive their original investment back or they can convert to common stock, depending on which is more favorable.

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Creating a SAFE

While there are some standard SAFE templates available on the internet, founders should be cautious about downloading and using these without legal counsel. First, while the “SA” in SAFE stands for “simple agreement,” these instruments are anything but simple. They are actually complex legal documents. If you haven’t read it, or have tried to read it but don’t understand it fully, don’t use it without getting expert legal help.

Second, the newer post-money SAFE that’s available on the internet in its original form is highly dilutive to founders. It’s a mistake to think that Ycombinator, which makes this version of the SAFE available, is some benevolent organization that puts the SAFE on the internet for free because they want to help founders. The truth is that Ycombinator is an investor, and they have drafted the post-money SAFE to benefit investors like itself, not founders. So founders should make sure to use a modified form of the post-money SAFE that removes the excessively dilutive language.

Third, SAFEs, like any legal document, can be modified to suit your needs. If you are the founder of what you hope will be a wildly successful, high growth company, then it makes sense to customize SAFEs to benefit your company. Taking a one-size, fits-all template off the internet and using it blindly is not necessarily the best approach. Sure, you might save $500 in legal fees today, but end up leaving $20 million on the table down the road.

As with all financing agreements, negotiations are expected. Investors and startups both need to protect their interests, and that’s why working with a lawyer who has experience is in your best interest.

The Benefits of a SAFE

A SAFE has advantages for both startups and investors. These include:

Not Debt Instruments

Debt is a problem for many startups. Often, it is this very problem of debt that causes a startup to fail.

Although similar to convertible notes, SAFEs are not debt instruments. The SAFE will not accrue interest, so when the SAFE converts, only the investment amount is converting, not the investment amount plus accrued interest. This means less dilution for the founders. Also, the SAFE does not have a maturity date where you must repay the investment. In fact, a SAFE may never actually convert to equity.

SAFEs remove the threat of insolvency, creating a less stressful scenario for founders

Simple and Straightforward

A typical round of funding has a lot of moving parts, which can complicate the process. There is a lot of coordination involved to get investors aligned and ensure all documents are signed and money is wired on the close date.

A SAFE takes a more simplified approach.

The close can happen as soon as both parties are ready.
The agreement itself is straightforward, and there are fewer variables to negotiate.
Because negotiations are quicker, the transaction can proceed more quickly.

All of this translates to lower costs for both parties.

While SAFEs are straightforward, they are also flexible. Agreements are not standardized, so terms can be negotiated, including those related to conversion, dissolution rights, and repurchase rights.

Founders Maintain Control

For founders, one big advantage of a SAFE is that it allows them to acquire the funds they need without having to issue equity (yet). SAFE investors do not hold equity in the company until the SAFE converts, so they have no voting rights. It is also extremely rare for a SAFE investor to get a seat on the board of directors.

No Repayment of Principal

SAFEs are considered a founder-friendly option because founders are not required to pay back the investment if the agreement never converts into equity. This reduces the financial risk for founders, but it also has other indirect benefits.

Investors will have a vested interest in helping the company succeed because their return is tied directly to the company’s success. For this reason, investors may contribute more than just funds. They may also offer mentoring and access to valuable industry contacts to help the startup grow and succeed.

Attractive to Investors

A SAFE is an attractive option for investors due to the potential for high returns on their investment. If the startup is successful, its equity may appreciate significantly.

Early investors are also protected by the conversion discount or valuation cap, so they may be more willing to take a risk on the startup.

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Is a SAFE the Right Option for Me?

Startups have several options when it comes to funding. A SAFE is an attractive one, but is it the right choice for you?

That can be a challenging question to answer without the help of an experienced professional well-versed in startup formation and funding.

At Kinetic Law, we work with startups to provide hands-on legal support, consultation, and oversight on crucial decisions such as these.

Out of our Cincinnati office, we can serve clients virtually throughout Ohio and California, including Silicon Valley, the San Francisco Bay Area, San Diego, and Los Angeles.

Contact us today to discuss your startup funding needs. Our experienced team is ready to help you.

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