A Primer on SAFEs
In early venture financings, a common investment instrument is a SAFE (simple agreement for future equity). SAFEs were created by Y Combinator to simplify negotiations for a convertible note. There are only a few terms that are typically negotiated in a SAFE. Those terms are the valuation cap and the discount rate, one or both of which can be present in a SAFE.
The valuation cap is the highest amount at which the SAFE will convert into equity. In practice, this means that holders of the SAFE note will receive equity at a lower share price than subsequent investors if the company’s valuation in a subsequent funding round exceeds the valuation cap. For example, if a SAFE has a $2 million valuation cap and the company later raises funds at an $2.5 million valuation, then the holders of the SAFE note will receive equity equivalent to the amount they invested based on the $2 million valuation instead of the $2.5 million valuation (meaning they would receive 25% more equity in this example).
A discount rate is a percentage at which SAFE holders will have the amount invested through the SAFE convert to equity in the event of a future equity financing. It is very important to note here that the discount rate is not stated in the same terms as a retail sale price. In retail, something is on sale for 20% off. The same discount expressed as a discount rate for a SAFE is 80% and that represents a material difference. The way a discount rate works in practice is like this: If a SAFE has a discount rate of 80% and the company subsequently raises equity capital at $10 per share, then the holders of the SAFE will receive equity in that subsequent raise at $8 per share.
For companies, SAFEs can be desirable due to their relative simplicity. Since there are only a few terms up for negotiation, SAFEs often close faster than traditional equity rounds. A SAFE is also not a debt, so there is no need to pay interest and no risk of the company defaulting on the instrument. There is also no deadline on a conversion to equity in most standard SAFE forms, so the company is given flexibility in timing any future equity round.
Potential negatives for companies include pushing away the sort of sophisticated investors who could provide more than just capital and making it more difficult to raise future equity if the discount rate or valuation cap is not properly set and this creates a valuation floor that the company cannot subsequently reach. A SAFE can also be used to procrastinate valuing the company, which can create all manner of problems later.
More sophisticated investors are increasingly hesitant to agree to a SAFE as opposed to more traditional convertible debt or equity deals. The reasons why are that the investor receives no guarantee that the SAFE will ever convert to equity, a SAFE investor cannot declare the company in default, and there are certain tax disadvantages for the investor in using a SAFE. The most important downside for investors is the first, that the SAFE may never convert. If the company fails, then this outcome is little different than had the investor taken a preferred equity position in the company when making the investment. But there are scenarios in which the company is successful and the SAFE still never converts to equity If a company becomes cashflow positive and is able to bootstrap subsequent to taking on SAFE money, then the SAFE will never convert to equity and the investor will be left out in the cold.
SAFEs can be a great option for early-stage financings, but there are potential downsides. If you are considering using SAFEs in order to obtain financing for your company or are considering investing a company using a SAFE, contact us at email@example.com to schedule a consult to determine if SAFEs make sense for your situation.