A SAFE agreement is a financial contract that is written between investors and startups. It is difficult to get a startup off the ground without enough funding. A startup may get help from family, friends, bank loans, and government programs.
Another way that entrepreneurs raise money is by going through series funding. For most founders, this starts with pre-seed funding and can go up to Series E. A Safe Agreement is an alternative way that a startup can get the financing that they need to get to the next stage.
What is a SAFE agreement?
SAFE stands for Simple Agreement for Future Equity. It is a new type of security that was introduced in late 2013 at Y Combinator. Since then, almost every YC startup and many non-YC startups have used this method for early-stage fundraising. SAFE agreements are a streamlined alternative to convertible bonds.
With a SAFE agreement, a startup can receive investments that are then converted to future equity in the company. These simple agreements are typically about 5 to 10 pages long. There are no interest rates or maturity dates on these notes. The valuation cap is the only negotiable item on a SAFE agreement.
How do SAFE agreements work?
When founders use traditional funding round, they will find investors that agree to a valuation with them. Then the investors receive shares in the company that is proportioned by how much they invested and the agreed valuation. The challenge with using traditional funding methods is that it is often difficult to agree with a valuation.
For example, if let’s say that you wanted to raise $1 million, but your investors will only invest $250K in your business now. Although it’s not the amount you wanted, the $250,000 investment could be useful to your business now. It probably isn’t going to make much sense to go through a funding round for just the $250,000 investment now.
SAFE agreements allow a founder to receive that $250,000 investment without going through a round of funding. Instead, you will promise to give these investors shares that are based on the valuation that’s agreed with the new investors during that round.
SAFE agreements are not debt instruments. These agreements work more like a warrant, a form of equity instead. Investors have the chance to convert their investment to equity when a Preferred equity round of funding is raised at some point in the future.
There are only a couple of types of SAFE notes since there are only two negotiating points in them. The types of safe notes based on these terms include:
- Cap, no discount – There are a valuation cap and no discount on these SAFE notes.
- No cap, discount – There is no valuation cap, however, a discount on the future price of the share will occur when the note converts.
- Cap and discounts – Both a valuation cap and discount exist on these SAFE notes.
- Most Favored Nation, no cap, no discount – There is a most favored nation provision, however, there’s no valuation cap or discount.
If a company fails, the money that’s left in the company is returned to investors. This money doesn’t come out of the founder’s own pockets, rather the company’s. That is because the liability is on the company, not the founder individually.
Investors should also be aware that SAFE agreements do not give you voting rights. That’s because SAFEs aren’t representative of current equity stakes. Hence, you don’t receive voting rights as you do with common stocks.
What are the Advantages and Disadvantages of SAFE Agreements?
Using SAFE agreements, startups can avoid offering up equity in exchange for funding during their early stages when they don’t have any high value yet. Here are many benefits of using SAFE notes including:
- Simple – The clearest and powerful benefit of SAFE notes is that they offer much more simplicity than convertible notes. The document is typically around 5 pages long, without a maturity date, or interest. SAFE note deals tend to move faster than convertible notes because there are fewer negotiable items to cause delays in the process.
- Flexible – Using SAFE notes, it’s not necessary to complete a valuation for the company. This offers startups a lot of flexibility. Plus with SAFE notes, founders don’t need to be concerned with worries about potential insolvency or cash flow issues. That’s because there are no maturity dates or repayment obligations.
- Ease of negotiation – A big difference with SAFE notes from other convertible bonds is there isn’t much to negotiate on. The main negotiation point is the valuation cap.
- Equity conversion – Although there are no maturity dates, there is a valuation cap. During the next round of funding when equity is raised, SAFE noteholders will receive their equity. This conversion to equity to both investors and founders is fair.
- Proportional benefits – Investors could be entitled to better benefits when the SAFE notes are converted in proportion to their original investment. For example, a common perk for these investors is to be offered preferred stock.
- Accounting – SAFE notes are on a company’s capitalization table like over convertible securities. This makes accounting for SAFE notes straightforward.
- Favorable provisions – There are provisions built into SAFE notes for change of control, dissolution of a company, or early exists. Investors also have favorable provisions such as discounts and valuation caps.
SAFE agreements have many benefits for both investors and founders. But you should take note of the drawbacks that exist. Here are some of the disadvantages that may exist with using SAFE notes instead of other options:
- Risk to investors – Since SAFE notes aren’t debt instruments, there’s a chance that they won’t convert to equity. Hence, there’s no requirement for repayment.
- Familiarity gaps – SAFE notes are still relatively new. So lawyers and investors may have less familiarity with them.
- Incorporation requirements – To offer SAFE notes, a company must be incorporated. Since many startups are LLCs, that means they will need to go through the incorporation process before being able to even issue SAFE notes.
- Fair valuation costs – A fair valuation (409a) could be triggered by SAFE notes. A company may need to allocate funds to cover these expenses that would have otherwise been used for activities like product development.
- Lower returns – No interest is accruing on these SAFE notes. This isn’t a problem when it’s a short-term investor. But once you’ve held this investment for over a year, this starts to become a case. There’s a greater return on investment for noteholders that accrue interest. In addition, this creates motivation for a company to close an equity round.
- Dilution – A possible scenario that many investors don’t consider is the valuation of the business in the future. There could be potential dilution implications that are risked.
- Dividend distribution – SAFE noteholders don’t have to be paid dividends due to a loophole. The goal of a SAFE note is to gain equity, so this might not be a problem for investors.
What is the difference between a SAFE and a convertible note?
SAFE notes and convertible notes are very similar to one another. Both are offered to investors who seek to invest in early-stage companies. SAFE notes and convertible notes offer a discount on the next round (in terms of convertible notes, this is during the current round). They can be obtained without a valuation cap and transform into equity in the future.
If you are seeking an early exit, either of these notes has mechanisms in place for these changes in control. For example, SAFE notes provide investors with the option of conversion to equity or 1x payout at the cap amount when participating in a buyout.
Protections like valuation caps, financial perks (i.e. discounts), and the ability to get out early are also both features of these notes. Value maxims, savings, and most favored nation clauses are also similar for convertible and SAFE notes.
Despite having so many similarities, SAFE and convertible notes have some very distinct differences. The reason that SAFE notes were created was actually to make them less expensive and faster than convertible notes.
SAFE notes don’t have a maturity date or accrue interest like convertible notes do. That means that investors have an end date in mind too when they will be paid when opting for convertible notes. This maturity date also comes with interest that must be paid to the investor by the company. The interest note on convertible notes typically will range from 2% to 8%.
If a startup wants to use convertible notes, the process of finalizing a deal is much slower when compared to SAFE notes. It should be noted that creating convertible notes can be done faster with help from a lawyer.
Another key difference between a SAFE note and a convertible note is that investors can’t foreclose on a company’s assets with a convertible note. That is because convertible notes are at the top of the cap table but are “unsecured” or flexible.
Finally, convertible notes allow you to change your current round of stock. Convertible notes can be transferred once the agreed-upon minimum amount is a date or a date that’s mutually agreed on. This is called a “qualifying transaction takes place”.
SAFE notes don’t have this control for entrepreneurs who must allow the conversation to take place when any number of investments are accrued.
Important Terms to Know with SAFE Agreements
There are a number of terms that are important to know when considering the use of SAFE agreements. Here are the key terms that you should understand:
Valuation Cap – This puts a maximum price on the price of a stock. That means that investors get more shares, the lower the price is. For example, let’s say that you invested in a startup that has a valuation cap of $10 million. The startup raises its Pre-Money Valuation to $20 million. The stocks you receive will be priced off the $10 million dollar number. However, if the value of the company is set at $5 million during the next round, that will be the price of your shares.
Discount Rate– This is the predetermined discount that the SAFE note will convert to in equity when a triggered event occurs. This event is typically the next round of funding. Think of this as a coupon that you might use at a retailer. For example, if you have a 10% discount coupon for your purchases at Bed Bath and Beyond. In a Series A, an investor will pay $100 per share, whereas a SAFE investor will be able to buy their shares at $90.
Liquidation Overhang – There could be a liquidation overhang problem when there’s a valuation cap. The SAFE investor has more liquidity preference in their Series A stock than they actually paid in this scenario. A negotiation point that a founder can make is to have those SAFE notes convert to a separate “sub-series” of Series A. The only difference between the series “A-2” stock and the regular Series A stock is the lower liquidation preference. This adds complexity to the transaction but resolves this overhand problem.
Pro-Rata Rights – Also known as participation rights. Investors can use this to invest more funds to maintain their ownership percent after the financing round that the SAFE notes were converted to equity. During this equity financing, these pro-rata rights allow investors to pay the new price of the round instead of the price paid when the SAFE converted.
Most Favored Nations Provisions – There is typically the MFN provision in the terms of a SAFE. The MFN provisions require the company to disclose to initial investors if another SAFE note is issued. The investor can then ask for the same terms if this second SAFE is better than the initial SAFE.
Is a SAFE agreement viable outside the US?
Generally speaking, SAFE agreements are not available outside of the United States. There are two primary reasons for this.
The first is that SAFE agreements are written with U.S. law in mind. That needs to adapt to the country that the company resides in.
The second reason the language and assumptions about items like future funding rounds are specific to the U.S. They may not make sense in the context of a different company.
There are some options in certain markets that are available, however. For example, UK companies that want to raise investment money from U.S. investors may consider using SeedLegal’s UK version of a SAFE.
Where can I find SAFE agreement templates for my startup?
Startups that are looking for SAFE agreement templates to use can find them on Y Combinator’s website. They have several different versions based on the type of SAFE agreement you are seeking.