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SAFE Agreements—Not So Standard Anymore


Introduction


Obtaining financing can be a significant challenge for start-ups who don’t have a valuation. The Y-Combinator created the SAFE agreement to address this challenge. The SAFE agreement is a bridge investment vehicle for start-up companies. It is intended to simplify seed financing for start-ups and enable founders to move toward equity round financing. Today, SAFE agreements are used for more than bridge financing, and the amount of money invested has increased to amounts that are more like an equity financing round. To accommodate these changes, the Y-Combinator modified the SAFE form. This blog discusses the SAFE agreement, how it has evolved, and alternative options for start-up funding.


What is a SAFE Agreement?

A SAFE, or Simple Agreement for Future Equity, is an agreement between an investor and a company which provides rights to the investor for future equity in the company without determining a specific price per share at the time of the initial investment. SAFE agreements are used by entrepreneurs and start-ups to attract investors and raise money in the seed-funding rounds. Here are some common terms you will find in SAFE agreements:

  • Discount - SAFE agreements can include a discount. The discount is used if the SAFE investor money converts in future financing rounds and the valuation was at or below the valuation cap.

  • Valuation Cap - Valuation caps are used to obtain a more favorable price per share in the future by setting a maximum convertible price. They reward investors for taking on additional risk.

  • Pre-Money or Post-Money - Pre-money or post-money refers to valuation measurements that help investors and founders understand how much a company is worth. Pre-money means the valuation is before new investor money. Post-money means the valuation includes the capital raised in that round.

  • Pro-Rata Rights - Pro-rata rights allow investors to add more funds to maintain ownership percentage rights following equity financing rounds. The investor pays the new price versus the original price.

  • Most-Favored Nations Clause - Most-favored nations clauses (MFNs), also known as non-discrimination clauses, require start-ups to give the same privileges to all investors.

Why are SAFE Agreements so Popular?

Start-ups can have challenges attracting new investors because they don’t have valuation and performance indicator data. A SAFE agreement can help solve these challenges by enabling investors to defer valuation to a future trigger event. Examples of a trigger event include the company being acquired by or merged with another company, or the company’s initial public offering. With a SAFE agreement, the investors are buying the right to equity in the future, when the start-up has more performance data, and institutional investors can properly value it.

What are the Pros of Using SAFEs?

The pros of SAFE agreements include:

  • Simplicity. A SAFE agreement is short and straightforward, with no end date or interest.

  • Shorter Negotiation Time. The use of the SAFE form can streamline negotiation and save transactional and legal costs.

  • Conversion to Equity. Investors can change their investment to equity later; the SAFE agreement does not have a predetermined date of conversion.

  • Flexibility for Start-ups. The lack of a valuation, pre-defined terms, and a maturity date gives the startup a great deal of flexibility with minimal expectations.

What are the Cons of Using SAFEs?

The cons of SAFE agreements include:

  • No expiration date. A SAFE never expires. It only converts upon the occurrence of certain events like equity financing, a liquidity event, or a dissolution event. If such events don’t take place, the SAFE continues to exist unless otherwise stated in the terms.

  • No Interest Rate. It isn’t debt, so it doesn’t bear any interest.

  • No Qualifying Equity Round Description. SAFEs can convert at any equity funding round when the valuation of the business is possible. There isn’t any predetermined minimum qualifying amount to be raised at the equity financing for SAFE to be converted.

  • Deferred Valuation Clause – The valuation of the company is deferred to the future.

Investor Beware: Increasing Changes to the SAFE—Not So Standard Anymore

The original SAFE agreement was based on a pre-money valuation. In 2018, Y Combinator amended its SAFE form to be based on a post-money valuation because of the expanded use of the form and the larger capital investments. The information below outlines the key changes.

  • The valuation cap is a post-money valuation, so investors have a better idea of the investment outcome.

  • The pro-rata rights provision to all investors was removed; this granted investors the right to participate in the equity round financing following the round in which the SAFE converted and maintain their ownership percentage.

  • Investors can include an optional side letter which grants the investors the pro-rata rights when the SAFE converts to equity. This enables the start-up the flexibility to decide whether they want to offer pro-rata rights to their investors.

  • The SAFE includes a clause that neither party can modify the form, however, it does allow amendments by written consent from a majority of SAFE holders. To amend the SAFE, the company must solicit the consent of every investor (even if consent is not granted), the purchase price may not be amended, and all investors must be treated in the same manner in the amendment.

  • Investor payout in liquidity events is streamlined if the company is acquired. Rather than requiring the investor to choose between a cash payment or common stock, investors automatically get the larger portion of their investment amount or the proceeds from the acquisition as if they had converted to common stock.


The Use of Side Letters to Negotiate Ancillary Terms


A side letter is a side agreement between the company and the investor made at the time the investor invests in the SAFE. The side letter can add provisions to the SAFE, or it can change (amend) provisions in the SAFE. The SAFE form includes language for certain rights that are sometimes granted to SAFE investors, such as a most favored nations clause and a pro-rata letter. A most favored nation clause says that if the company gives rights to another SAFE investor that are better than the rights granted to an existing SAFE investor, then the existing SAFE investor can elect to have those better rights incorporated into the SAFE agreement. A pro-rata letter gives a SAFE investor the right to purchase more shares in a company if the company raises a further round or rounds of financing. This gives the founder and investor the flexibility to meet unique needs.


Alternative to SAFE Agreements

There are alternatives to SAFE agreements if that vehicle doesn’t meet the needs of founders: convertible notes and a KISS. Convertible notes are a form of debt that converts into equity, at a discount, upon certain events like a company sale. With seed financing, investors loan money to a startup as its first round of funding; and then rather than get their money back with interest, the investors receive shares of preferred stock as part of the startup’s initial preferred stock financing, based on the terms of note. A KISS (Keep it Simple Security) is a convertible security that converts into equity (preferred stock) at a given qualifying event. A KISS also converts into preferred stock based on the discount rate and valuation cap agreed on within the KISS legal documentation. Which agreement is better depends on the founder’s needs and the company and corporate shareholder structure.


Conclusion

SAFE agreements have benefits for founders and investors. For founders, the SAFE agreement helps them secure the seed money they need to launch their companies. SAFE agreements give investors more flexibility and certainty when funding start-ups. Without the standardization SAFE agreements once had, it is important these agreements are professionally drafted and negotiated so both parties understand the intricacies of the agreement and receive the benefits they desire.



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