What Is A SAFE (Simple Agreement for Future Equity) : Things You Need To Know About SAFE
In this article you'll find information on:
- What Is A SAFE and what is it for
- How does SAFE work
- Four Main Parts To An Actual Safe Contract
- Why Use Safe?
- Differences Between SAFEs and Convertible Notes
- SAFE Note Disadvantages
As a start-up, it can be difficult to assign a value to the company accurately. The rise and fall can be furious and understanding various funding strategies that best fit your business is vital. That’s where a SAFE comes into play— it’s convertible security that allows you to postpone the valuation until a later time. A SAFE is neither debt nor equity, and there is no interest accruing or maturity date.
What is SAFE?
A SAFE, or Simple Agreement for Future Equity, was created by the team at Y Combinator, an American tech startup accelerator. and has been a popular method for investing at the earlier stage of a company. It is an investment instrument that converts the holder’s value into the equity of the issuer upon certain triggering events. As the name suggests, SAFEs were designed to be simpler, more streamlined, and an easier way for founders and investors to align quickly on an investment.
SAFEs are designed to give a company access to funding without giving up equity. They work by allowing founders to raise capital while they retain control over their business and its future. Startups often use SAFEs with high growth potential but little or no revenue yet because they provide investors with an option to convert their investment into equity at some point, in the future.
SAFE is not a loan, so there is no debt associated with it, and you do not have to pay it back if you’re the entrepreneur from a legal perspective, and it is also not equity.
To understand how SAFEs work, it is helpful to have some context as to how they were created.
How Does Safe Work? - Four Main Parts To An Actual Safe Contract
1. What Are the Trigger Events - You must have eligible funds in the future. This means that a certain amount has been raised in a future round of financing that will encourage all safe holders to trade their shares. This always depends on the terms of the SAFE contract, and this amount is relatively small compared to the startup's ambitions and how much money they want to raise in the future.
The reason we are organising this eligible funding launch event is that we want our businesses to be able to raise funds when they need them. It may not be a full-price round, but it allows all other SAFE owners to operate the business early.
2. Valuation Cap - This protects investors early on by preventing excessive dilution with very high valuations in the future. In other words, it serves as a valuation ceiling to protect investors, as it shields them from taking unnecessary risks from the start, which may have the highest risk of failure. This is another way SAFE investors get better stock prices than later investors. When a company raises funds at a price above the ceiling, SAFE investors can trade at the ceiling price.
3. Discount Rate - It works in the same way as a rating ceiling. It offers early investors a discount to compensate for the initial risk of investing in the company. This gives the custodian a discount on what future investors will pay.
The discount rate is usually 10-30%. For example, for a future round of financing, an investor invests $10 million and receives a 20% discount on that amount. The evaluation as well as the discount rate may work together or may have only one of these conditions.
4. Pro Rata Rights - This is not always included. Equity investors ( people who invest money into a company in exchange for a share of ownership in the company) may invest additional funds to retain ownership of equity financing after the SAFE is initially converted to equity financing. This gives SAFE owners the ability or right to retain ownership by investing in future rounds of financing, which SAFEs often do not include to facilitate small investors as their business grows and matures.
Unlike custom convertible notes, SAFE is designed to be used directly for rounds of low-cost financing startups.
When you try to invest in a startup, you always face two problems. First, you need to know what the business rating is. If your business is more attractive when you use SAFE, it is better defined than most risks. The second issue SAFE addresses are the time and cost of creating legal documents. Often, advanced investors want better conditions and negotiate differently. With SAFE, you don't have to do this, because it's a simple transaction for future stocks. . SAFE is good for both entrepreneurs and investors because it is time-efficient, and entails less hassle from a legal and accounting standpoint.
As with convertible notes, the terms of a SAFE bond include a valuation cap and a discount rate that will be applied to the conversion in the next round of shares. However, there is no expiration date or interest rate. This is useful for the founders, but not always attractive to investors.
Why use SAFE?
SAFEs were designed to be used directly for unpriced funding rounds at startups.
When you try to invest in an early-stage company, you will always run into two issues. The first is attempting to determine the valuation. When you use a SAFE, you are simply deferring that issue until the company is more well-defined than many of the possible risks.
The second issue addressed by SAFE is that it reduces complexity. The terms and conditions of a SAFE are not usually open to negotiation which makes the fundraising process as hassle-free as possible and ensures a straightforward process.
Differences Between SAFEs and Convertible Notes
SAFEs remain outstanding until a conversion event occurs or the issuer is acquired or liquidated. As a result, investors and companies do not spend time setting and extending expiration dates, and the company's operational and financial decisions are not affected by future expiration dates.
- No Interest rate. This is the annual rate at which interest on a loan accrues, and accrued interest may have to be repaid or added to the number of shares received by the holder of interest upon conversion. A SAFE does not earn interest.
- No Maturity date. This is the date on which the issuer of a debt instrument may be required to repay the initial investment amount as well as any accrued interest. There is no maturity date for a SAFE.
SAFE Note Disadvantages
SAFEs are practically simpler than convertible bonds, but they have disadvantages and disadvantages because they do not have a maturity or interest date. SAFEs do not have an expiration date and can be converted to the next evaluated financing round, so SAFEs cannot be converted unless the company participates in the next evaluated financing round.
Due to the complexity of the SAFE contract, the terms and conditions must be drafted accordingly. By signing the contract, you conclude a complete and conscientious contract. Securities lawyers are well versed in financial law and have extensive experience with startups. Get legal advice before offering or accepting a SAFE contract. This is the basis of how SAFE works. For more information, see the Introduction with Y Combinator’s article, which includes an introduction to SAFE and examples of articles with different rules. Some various attributes and terms can be added or changed in the documents listed on the Y Combinator site.