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What is a SAFE Agreement?
Startups are all about innovative ideas, but it takes money to get these companies going. For many startup founders, this is where the trouble begins. Acquiring funding can be difficult enough, and in many cases, startup founders have to agree to terms that are unfavourable in order to get the capital they need.
To address these issues, Y Combinator introduced the idea of the SAFE (Simple Agreement for Future Equity). A SAFE is an investment agreement that not only simplifies the terms for new startups, but it also helps them to get terms that are a little better than with conventional funding options.
Issues with Early Stage Funding
Once a startup is founded, the owners usually need money quickly. They have to fund their day-to-day operations and they need capital to develop their ideas. Under conventional funding models, the founders would issue convertible promissory notes or hold a preferred equity round.
Since convertible promissory notes are a form of debt, they come with a range of strict obligations. They have interest rates and maturity dates. Upon maturity, the startup has to pay the money back at interest or convert its value into equity in the company.
A round of equity funding avoids the problem of taking debt, but it comes with its own issues. To start, holding a round of equity funding can be expensive and complicated. Not only that, but it forces the startup to perform valuation before the company is established. This usually leads to a lower valuation and it allows investors to take a larger piece of the company.
How SAFEs Avoid These Problems
A SAFE is a simple, one-document agreement that helps startups to avoid many of these issues. Unlike a promissory note, it is not debt and it does not come with interest or a maturity date. Along with that, the valuation of the company is deferred to a later date, so the founders do not have to accept the lower valuation that comes with a round of early-stage equity funding.
While these are some of the key benefits for the founders of a startup, SAFEs also offer benefits to the investors. There is a risk to providing funding to an unproven company, so there has to be some upside to attract investors. In general, the benefit to investors is that they have a right to purchase shares under favourable terms upon some future event.
- One common mechanism for this is the right to a discount when priced shares are sold. Instead of having to pay the same price as all of the new investors, the holder of the SAFE contract will get to buy shares at a lower price. A common discount in this type of agreement can run anywhere from 5-30%.
2. A valuation cap is another way to offer value to investors who may agree to a SAFE. With a valuation cap, the investor is entitled to equity at the price of the cap. If the company’s real valuation is exceptionally high, this guarantees them a certain amount of equity regardless of the actual valuation.
3. Pro rata rights are another feature of SAFEs that can be used to attract investors. This guarantees the investor the right to participate in future financing rounds. Generally, pro rata rights are only given to investors who contribute a significant amount to the early-stage funding of a startup.
Summary
Using a SAFE contract can be an advantageous way to fund a startup, but it might not be the right option for every company. Startup founders should investigate all of their options and consider consulting with an expert before making any agreement for funding.
This article does not constitute legal advice.
The opinions expressed in the column above represent the author’s own.
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