A Simple Agreement for Future Equity (SAFE) is a type of convertible security used by investors and startups to facilitate investments into businesses without having to go through the lengthy and expensive process of doing an equity financing round.
SAFEs are an increasingly popular way to structure an investment in a startup. They have been used by many successful startups, including Dropbox, Uber and Airbnb.
What Is a SAFE Agreement?
A SAFE is a Simple Agreement for Future Equity. It is a contract between an investor and a company that gives the investor the right to receive equity in the company at a future date for the cash contribution done now, typically in connection with a future financing round.
SAFEs are structured as loans and will usually be converted at a discount to factor in the additional risk the investor is taking.
Benefits of using SAFEs
SAFE investments have become increasingly popular in recent years as a way for startups to raise funds and finance their business without giving up equity or taking on debt.
Under a SAFE, investors provide funding to the startup in exchange for the promise of future equity. If the startup is successful, the investors will receive equity in the company. However, if the startup fails, the investors may not receive anything.
SAFEs were created by Y Combinator as a way to simplify the process of raising funds from investors. Unlike traditional equity financing, which involves issuing shares in exchange for investment, SAFE investments allow startups to raise money without giving up any ownership stake right away.Since no shares are issued to the investor, there is no need to set a valuation and determine the price at which equity will be bought.
This makes them an attractive option for early-stage companies seeking to minimize dilution and postpone the valuation event. As a result, SAFEs have become a popular option for startups raising capital.
What are the main components of a SAFE?
The main components of a SAFE are the investment amount, valuation cap, discount rate, and conversion events.
- The investment amount is how much money the investor puts into the business.
- The valuation cap sets the maximum valuation that can be used to calculate the amount of equity that the investor will receive. If the cap is lower than the market valuation, then the SAFE investor will convert at more favorable terms than the new equity investor.
- The discount rate provides a percentage reduction to the price per share to compensate an early SAFE investor for taking on the risk.The valuation cap and discount rates determine how much the company is worth and how much return the investor will receive. It’s typically either one or the other, depending on which offers the lowest price, benefitting the investor.
- The conversion triggers are events that cause the investment to convert into equity. Typically the triggers are new qualified financing rounds (equity investments), if the company is acquired by another entity or an IPO.
Having a SAFE in place lets both the business and the investor know what to expect. This can help avoid any misunderstandings or disagreements down the road.
There are 4 versions of the SAFE:
- Valuation cap and no discount (standard SAFE).
- Valuation cap and discount.
- Discount but no cap.
- No cap, no discount, MFN (Most Favored Nation clause that allows all SAFE investors to have the same terms based on the most favorable one. Let’s say a new SAFE investor has better terms. That allows the earlier SAFE investors to adopt the same more beneficial terms into their agreements).
Other terms that can be included in the SAFE:
- Pro-rata rights: SAFE investor can purchase additional shares at the next round to maintain the same percentage of ownership.
- Liquidity event clause: investors can get their money back or choose to convert their investment to shares at a valuation cap when a liquidity event occurs.
- Dissolution clause: an investor’s right to get money back if the company gets dissolved.
SAFE agreement vs Convertible Note
Convertible notes are debt instruments that can be converted into equity at a later date. What differentiates convertible notes from SAFEs is that convertible notes have a maturity date (when the loan has to be repaid, converted or postponed) and they can earn interest for the noteholders. You can read more on convertible notes here.
SAFEs do not accrue interest, and they don’t have a maturity date. Moreover, for SAFEs, there is no size requirement regarding an equity investment that triggers the conversion.
As a result, SAFEs are often less expensive for startups than convertible notes. However, both options can be useful for raising funds and financing a startup.
Pre-money vs post-money SAFEs
There are two types of SAFEs: pre-money and post-money. There is a crucial distinction between pre-money SAFEs and post-money SAFEs. The difference arises in the uncertainty around investments and when shareholders have to be diluted.
Failing to agree on the SAFE type when negotiating will lead to ambiguity in the future when a new financing round happens and when the SAFE investment is converted. In that case, unexpected surprises and stressful negotiations can surface.
The key difference between the two is that for pre-money SAFEs, investors and startups don’t know the percentages that investors will own until after all the conversions occur since they all affect each other.
It is one of the drawbacks of a pre-money SAFE. It is easy to lose track of dilution for founders and it adds more uncertainty for investors.
That’s why the people behind Y Combinator (the creators of SAFEs) came up with a new agreement - a post-money SAFE. In post-money SAFEs, investors lock in a percentage of the company by investing their money at a predetermined valuation cap.
Pre-money SAFEs are diluted by all funding and other SAFEs, while the post-money SAFEs are diluted by the new investment event (the priced round that triggers the conversion) only. The post-money SAFEs are harsh on founders since they are the ones that are being diluted when SAFEs are converted.You can read more about pre-money and post-money SAFEs and their step-by-step examples here.
Is a SAFE agreement equity or debt?
SAFEs aren’t equity or debt. These are simply contractual agreements that give the rights to equity in the future after a predetermined event triggers the conversion.
SAFE agreements don’t earn interest and are high-risk investments that can never be converted to equity if no trigger event occurs. Moreover, startups may not be obliged to repay the invested amount back.
7 things you need to know about SAFEs
- Simple Agreement for Future Equity (SAFE) is an increasingly popular form of financing for startups.
- SAFEs are a convertible security that gives the investor the right to company’s equity in the future.
- They provide a way to raise capital without setting a valuation, giving up equity right away and they offer investors the potential to receive favorable terms and a return on their investment if the company is successful.
- The key components of SAFEs are investment amount, valuation cap, discount rate, conversion triggers.
- SAFEs are different from convertible notes because SAFEs don’t have a maturity date and they don’t earn interest.
- There are 2 types of SAFEs: pre-money and post-money. Understanding the difference can save you from losing the majority stake of your company. Make sure to read about pre-money SAFEs vs post-money SAFEs examples.
- SAFEs aren’t equity or debt.