What is a SAFE agreement in VC funding?

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Key Takeaways

A SAFE (Simple Agreement for Future Equity) is a convertible loan that does not have a debt component.
SAFE is a contract (not a traditional loan) where an investor chooses to make a cash payment to a business in return for the negotiated right to turn that amount into stock if a predetermined trigger event occurs.
The amount of shares provided to an investor is determined by the amount of money invested and the capital raise valuation, among other factors.
A SAFE, unlike other convertible notes, is not a typical debt instrument. As a result, maturity dates and interest rates are often ignored.
Y Combinator developed SAFEs in 2013 to substitute convertible notes in unpriced rounds, but both tools are now being used simultaneously, depending on the investor's preference.

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What is a SAFE agreement in VC funding?

SAFE (Simple Agreement for Future Equity) is a type of financial contract that a startup company can use to secure financing during its seed funding rounds. Some see the method as a more entrepreneur-friendly alternative to convertible notes.

A SAFE is essentially a contract between a startup and an investor that gives the latter the right to obtain equity in the business in the event of some key contingencies, such as:

Future equity financing (also known as Qualified Financing or Next Equity Financing), which is typically led by an established venture capital (VC) fund or a non-traditional private tech investor
Sale of the business

The SAFE is similar to a kind of warrant in that it entitles investors to shares in the company, usually preferred stock, if the business:

Raises “priced” equity financing
Is purchased
Files an IPO

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Safe Agreement Y-Combinator

In late 2013, Y Combinator launched the safe (simple agreement for future equity) which has since been adopted as the primary instrument for early-stage funding by almost all YC startups and countless non-YC startups.

Although the safe might not be appropriate for all funding cases, the terms are designed to be - by and large - fair, taking into account the needs of both the startup and the investor(s). Although there is a trade-off between simplicity and thoroughness, we believe the safe covers most of the important and prevalent issues.

While we believe that it offers a good starting point that can be used without significant alteration in most cases, both parties are advised to have their attorneys review the safe.

How does a SAFE agreement in VC funding work?

To reward the investor for financing the company early, the business will issue shares at a discount to the stock price of the equity round or the liquidation scenario, similar to convertible notes.

The "per-share price" in case of an equity or liquidation event compounded by the discount rate is known as the "discount price." Since convertible equities such as the convertible note and SAFE do not specifically set prices on the company's stock, the fundraising round that they finance is known as an "unpriced round."

Technically, using a SAFE allows you to postpone valuing your business. Some SAFEs, like convertible notes, might have a valuation limit, or a maximum value at which the sum can be converted. So, when raising a round under a SAFE with a valuation limit, the parties are essentially negotiating a valuation.

Since the SAFE is not a debt, if the startup goes bankrupt well before the cash converts to shares, it normally offers to pay the investor a sum equal to the amount of the capital injection before paying its shareholders.

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Benefits of a SAFE Agreement in VC Funding

#1: Inclusion of valuable stipulations

Convertible notes are known to have valuable components -- and SAFEs have a lot of them as well.

For example, SAFE notes have important stipulations that include valuation limits, change of ownership, early exits for both investors and owners, business breakup, and any potential bankruptcy scenario, are all incorporated into the agreement.

#2: Simplicity

A SAFE note is a five-page document that has no interest rate or expiration date. SAFEs are a lot less complicated than convertible notes.

That’s not all ...

Furthermore, SAFE notes free up investors' time while encouraging the startup to move at a quicker pace with less paperwork. This is because investors are not expected to sign off on the company's decisions or attend shareholder meetings.

This generally results in a huge benefit -- and improved agility -- for early-stage startups, particularly those with limited capital, and helps them succeed.

#3: The Equity Conversion Option

Look:

Even if the equity conversion isn't predetermined, like it is in a convertible bond, investors can generally turn their investment into equity at any time.

When more investors join following investment rounds, the startup founders and the SAFE investor can settle on a timeframe for doing an equity conversion.

#4: Flexibility

SAFEs offer startups a lot of flexibility because the business doesn't typically need to be valued.

Since there are no repayment obligations or a maturity deadline on SAFE notes, you can simply focus on building the business.

Under such circumstances, you won't have to be concerned with cash flow or insolvency risks most of the time.

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Limitations of a SAFE Agreement in VC Funding

#1: Complicated Jargon

SAFE notes might seem simple to some -- but they incorporate more legal complexity than what the average person is comfortable with in most cases.

The document is 5-6 pages in length, which is not exactly short. To a lot of people, the parts containing legal terminology are difficult to understand, leading them to believe that the document is almost as hard to comprehend as any other legal document.

#2: Fair Valuation Expenses

It's possible that SAFE notes would necessitate a fair valuation (409a).

The ensuing professional services could require a portion of the company's budget, leaving a reduced amount of capital available for product development and other day-to-day startup-related expenses.

#3: Lack of Minimum Requirement

There is no minimum requirement for an equity round to convert with SAFEs.

Why does this matter?

A minimum requirement could prove beneficial since it gives the round credibility and meaning. A lack of minimum requirement implies that a SAFE note can be re-adjusted on a whim and that a smaller investor can compete by negotiating a better price.

#4: Absence of Familiarity

Since SAFE notes are comparatively new, there might be lawyers and investors who do not necessarily have the highest levels of trust, comfort, familiarity, and understanding of SAFE’s.

Convertible notes, on the other hand, have a longer track record and could be, for this reason, more appealing to investors (and lawyers).

Safe Agreement for LLC

Yes, LLCs are now doing SAFEs.

But there’s a catch.

The SAFE instrument (like convertible notes) needs to be tweaked to make sense for an LLC. In fact, SAFEs for LLCs are much rarer than SAFEs for C-Corps -- but they do exist.

As for C-corps, SAFEs are only used in a small number of situations. That's because their characteristics tend towards being pro-company (and anti-investor), and many investors are put off by what they perceive to be an imbalance.

Safe Agreement Template

Source

Check out more SAFE Agreement Templates on:

Silicon Valley Safe Agreement

The convertible note had been Silicon Valley's traditional funding instrument for seed-stage startups for the last few years. Even today, the convertible note remains the standard instrument.

That being said, as is customary in Silicon Valley, it metamorphoses. A lot.

The simple agreement for future equity (SAFE) was crafted by Y Combinator's Legal Dream Team in 2013. Y Combinator in Silicon Valley has been a trailblazer in many aspects, including pioneering the SAFE contract for startups and ensuring that it’s “used by almost all YC startups and countless non-YC startups as the main instrument for early-stage fundraising.”

While a SAFE contract is more or less meant to stay unchanged from its original form, it was created for the U.S. legal system and might require modifications when used elsewhere.

A basic understanding of a few key terms could help startups negotiate a mutually beneficial SAFE contract.

Safe Agreement Bylaws

SAFEs Aren’t Common Stock

SAFEs don't reflect a current equity stake in the business you're investing in. A SAFE is a contract that guarantees you a potential equity interest based on, in part, the sum you invested if — and only if — a triggering event happens, such as a new round of funding or the company's sale.

There's no assurance that these events will occur.

Unequal Creation

Different companies that offer SAFEs use different (or varying) terminology to define triggering incidents, and conversion requirements and conversion prices could be treated differently from one issuer to the next.

SAFE Conversion Triggers

The SEC states that the company's SAFE conversion might be caused by a variety of circumstances that may or may not occur in the company's future.

For instance, a SAFE could be activated if the business is purchased by or merged with some other company, whereas another SAFE could be triggered by the company's IPO of securities.

SAFE Conversion Trigger Failure

Despite the known triggers for SAFE conversion, it is possible that the triggers might not be activated. In this case, the SAFE will not be converted, leaving you (the investor) with nothing.

Know Your Rights

Apart from the trigger feature, there are a few other aspects of SAFEs that you should be aware of before signing the agreement with an issuer:

Terms of Conversion

These are the basic terms under which your SAFE investment is transformed into equity. For example, the terms of conversion include those terms which specify whether only your initial investment converts.

Right to Repurchase

The SAFE could include provisions that enable the company to repurchase your future right to equity rather than converting the investment to equity.

Right to Dissolution

When the business goes bankrupt, you need to know what happens to your SAFE and the money you spent. The right to dissolution specifies exactly that.

The Right to Vote

Since SAFEs do not reflect current equity stakes in the business, they typically do not give you voting rights like common stock.

However, there might be specific circumstances listed in the SAFE that give you a say in SAFE-related matters.

Doing a Safe Agreement for a Corp?

Since a SAFE equity arrangement gives investors a liquidation preference, it will be in violation of the requirement that an S-corporation issues only one class of stock (which the IRS has held to mean that all stockholders have the same preference in the case of a liquidation event).

Since the assessment of stock class is centered on the preference conferred in the event of a liquidation, it makes no difference whether or not the company plans to convert to a C corporation before the SAFE conversion.

Does Money from a Safe Agreement Count Towards Pre-Money Valuation?

If an investor and a company agree on a pre-money valuation, an investor's ownership is determined by:

Their contribution
The pre-money valuation; and
The round size

However, if an investor and a company agree on a post-money valuation, an investor's ownership is determined by their contribution and the post-money valuation, regardless of the round size.

Here’s the deal:

SAFEs have only recently evolved into the post-money SAFE. The first SAFE was designed to look like a convertible note. There was a lot of pre-money transition math involved in it. Even though there was no mechanism for expiration, it mentioned termination and expiration. It was designed to be used as a bridge instrument - and it sounded like one.

The entire option pool, even though the options haven't been distributed, is included in the estimation of the business capitalization under the pre-money SAFE, as well as the rise in the option pool that occurs in conjunction with equity funding, which is itself an undisclosed element at the time of SAFE investment.

The complete option pool is included in the post-money SAFE, but the increase to the option pool is usually omitted, eliminating an unknown variable.

Example of a Safe Agreement

Here is an example of a SAFE agreement straight from the SEC archives.

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