What is a SAFE?
In 2013, Y Combinators created a new form of agreement named “Simple Agreement for Future Equity,” also known as “SAFE,” a contract that allows startups or companies to raise investment capital in the seed rounds. A seed round refers to a series of investments in which a limited number of investors “seed” a new company. This money is often used to support initial market research and early product development. In this agreement, the investor is granted future equity rights in the company that triggers liquidity events. The term “liquidity events” means any circumstance that enables the company investors to realize the value of their investment that may result in an early exit. Unlike other financing instruments, SAFE is neither a convertible note nor a common stock. However, it an alternative to convertible notes and is similar to warrant (means a derivative that gives the right, but not the obligation, to buy or sell a security at a certain price before the expiration) but without any specific maturity date (means a due date). To simplify, it is a mechanism that encourages startups to seek their initial funding before series of investments.
The importance of SAFEs for startups
The SAFE agreement helps startups in the initial funding for their operations or to develop their products. The financing obtained through this agreement is not a loan, but an equity investment in the company as an investor lends the required amount without bearing any interest on the borrowed amount by the company, which is not a loan according to the parties. In the absence of loan interest, the investors receive the equity that lures them to implement its implementation is not complex but is flexible. The agreement grants investors future equity rights in the company, which is equivalent to their investment during the pricing round or only when the conditions under the liquidation clause are triggered, which may never happen. In addition, the SEC regulates and recognizes SAFEs, according to the Securities Act of 1933 and the Securities Exchange Act of 1934.
Difference between SAFE & Convertible Note (CN)
A SAFE is a convertible security, not a debt, while a Convertible Note is a debt. Unlike Convertible Note, SAFE does not have any fixed maturity period. In contrast, CN has a maturity period that allows investors to return on their investment with interest or equity equivalent to the invested amount plus interest. A startup raising funds cannot postpone its valuation under CNs due to a fixed maturity period. While SAFE is a convertible instrument, it authorizes a company to defer its valuation later. Deferring allows an investor a more significant return on the purchase of equity if the company valuation exceeds the capped amount.
Essential Terms to consider in SAFEs
Startups/ companies raise funds from an investor to deliver equity in the future for their operations or products. Both the parties must understand the agreement. In addition, five basic terms are essential in the contract: discounts, valuation caps, pre-money or post-money, pro-rata rights, and the most favored nations provision as the agreement involves future delivery of shares.
While the SAFE agreement is very simplified, investors, including the companies, should be aware of the risk involved as this agreement may not benefit both parties equally and depends on the structure and the investors’ bargaining power and intention. Furthermore, SAFE is a useful instrument to raise capital without giving the initial investor right as a shareholder. However, this right arises on conversion into equity.
Authored by Sujeet Karkala (Senior Associate).
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