SAFE Agreements 101 (Basics) – The SAFEst of All Convertibles

 

Saurabh Nathany explains SAFE Agreements.

SAFE is short for Simple Agreement for Future Equity, introduced by the Y Combinator, a leading Silicon Valley accelerator, as an open-source document for founders or promoters to raise seed capital.  

But When Does This Apply to You?

When you start your company, you are bootstrapping and typically using your savings to cover your operational expenses. Sooner or later, you will become cash deprived and require additional funds to continue growing. Then, you reach out to friends and family or an angel group to source angel investors. The easiest way for others to invest in your business is by entering into a SAFE agreement with your company (or iSAFE or other methods if your startup is based in India).

A SAFE agreement is entered into between the investor and the startup. In exchange for the investor’s capital, the company promises to issue shares to the SAFE investor in the future, preferably during an equity financing round (also known as a priced round). There are very few terms to negotiate, making a SAFE an efficient instrument to use for raising seed capital without incurring high legal costs. 

How Is a SAFE Beneficial to My Startup Company?

From the company’s perspective, A SAFE is a better alternative to a convertible note and a much simpler and more efficient alternative to issuing preferred stock. Unlike a convertible note, a SAFE is not a debt instrument and, therefore, does not come with an interest rate or a maturity date requiring the company to repay the debt. However, because there is no maturity date, a SAFE is junior in priority of pay-out compared to a convertible note in case the company folds. Here are some other advantages of a SAFE:

  • Simple and Easy to Negotiate: A SAFE consists of just five pages of terms. Typically, the conversion price is the only issue that needs to be negotiated.

  • Inexpensive: Because a SAFE does not have numerous terms to negotiate, it saves both the startup and the investor significant legal fees.

  • Straightforward Accounting: Similar to other securities that are convertible, a SAFE can be included in a company’s capitalization table.

  • Similar Provisions to a Convertible Note: A SAFE typically provides for three outcomes – (i) where the SAFE converts into preferred shares due to equity financing (i.e., the company issuing shares in exchange for investments as opposed to issuing SAFEs), (ii) where the company gets acquired before an equity financing, and (iii) where the company gets dissolved or shuts down.

  • Flexibility: The absence of a maturity date and pre-defined repayment terms provides a startup with total adaptability to any future circumstances that may arise.

How Does a SAFE Convert Into Shares?

A SAFE is intended to turn the SAFE holder into a stockholder. In a SAFE, the date of conversion is not predetermined. However, conversion generally happens upon an equity financing. The conversion price at which the SAFE converts depends on the conversion method contained in the SAFE, i.e., conversion at either a discount or the valuation cap. 

  • Discount Method: In this approach, the SAFE holder gets a discount on the price of preferred stock per share at which the company sells to new investors. There is, therefore, a monetary incentive for an early-stage SAFE investor.

  • Valuation Cap: In this method, the company’s post-money valuation cap (i.e., the total value of the company after the new investor has invested) is divided by the company capitalization (i.e., an aggregate of the total shares outstanding, total shares of the employee stock option pool, and other convertible instruments).

Once the SAFE converts into preferred stock, the SAFE is then terminated. A post-money SAFE inherently has an issue when multiple SAFE holders use the same post-money SAFE, especially with the valuation cap conversion method. We will discuss this in an article on Advanced SAFEs.

The erstwhile SAFE holder’s rights in the preferred stock flow from the stock purchase agreement between the new investor and the company. 

Conclusion

SAFEs are an excellent way for you to raise your initial rounds of investment to seed your tech startup.  

Disclaimer: This post is for education and information purposes only and should not be construed as legal advice. Please discuss your specific issues with your attorney.

 
Samantha Gee