SAFE Agreement: How They Work, Important Terms

Startups need to raise money, but it’s nearly impossible to attract new investors without discuss valuation and performance indicator data. While this may seem like a latent problem without a solution, the good news is that there’s an investment instrument, known as a SAFE agreement, that solves it.

Find out everything you need to know about SAFE agreements through the article below.

What Is A SAFE Agreement?

SAFE agreements, also known as simple agreements for future equity and SAFE notes, are financial agreements that startups use to raise seed financing capital and similar to a warrant. They’re an alternative to convertible notes and KISS notes and were introduced by Y Combinator in 2013. The terms and conditions of SAFE agreements determine the relationship between the startup and investor regarding equity rights for triggering liquidity events.

Triggering Liquidity Event

A ‘triggering liquidity event’ in a SAFE agreement refers to an event that causes the conversion of a SAFE into equity. These can include:

1. Equity Financing. If a startup raises capital by selling preferred shares to investors, the financing round can trigger the SAFE agreement holders’ investment to convert into equity, often at the discount rate or valuation cap.
2. Liquidity Event. A liquidity event is a broad category, but can include things like the sale of a company or an Initial Public Offering (IPO). If these happen, the SAFE agreement holders’ investment converts into equity before the transaction.
3. Dissolution or Bankruptcy. If the company goes out of business, dissolves, or files bankruptcy, the SAFE agreement holders may have rights to remaining assets of the company and can cause the investment to convert into equity.

Here’s an article that discusses SAFE agreements.

How Do SAFE Agreements Work?

It’s challenging to value a startup at the beginning of its inception. SAFE agreements solve this problem. They allow you to delay valuation until a future date while still having the opportunity to invest or raise capital.

Once the company grows, it will likely raise additional capital and subsequently increase in value. It’s this result that investors are trying to achieve. The SAFE agreement converts into company shares when new investors do priced rounds in the future.

Example of How Safe Agreements Work

Let’s say you invest $25,000 through a SAFE agreement. Since assigning a valuation to early stage companies is almost meaningless, the startup will leverage its SAFE agreement to find new investors to defer valuation to a future event. The investors are simply buying the right to equity in the future, when the startup has more traction and performance data that would allow an institutional investor to properly value the startup. At this point, your $25,000 would convert into equity relative to the valuation of the priced round. Early investors typically get a benefit from taking a risk, which includes discounts and valuation caps.

This article also discusses what you need to know about SAFE Agreements.

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Important Terms in a SAFE Agreement

SAFE agreements are powerful investing tools. However, there are important terms in SAFE Agreements that you must understand. The five terms we’ll consider in this article include discounts, valuation caps, pre-money or post-money, pro-rata rights, and the most favored nations provision.

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. For example, a 20% discount rate means an investors money would buy shares at a $8m valuation if the priced round was $10m (20% discount).

Valuation Cap

Valuation caps are another common term in SAFE agreements that investors can use 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.

As an example, suppose a startup is raising capital at a $10m valuation and the SAFE investor had a valuation cap of $5m. In that case, SAFE investors shares convert at the valuation cap ($5m) despite the startup has just been valued at a $10m valuation. SAFE investors are typically happy if the valuation cap comes into play.

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. It’s one of the most essential terms in a SAFE agreement. Pre-money means the valuation is before new investor money. Post-money means the valuation includes the capital raised in that round.

Here is an article about pre-money and post-money valuation.

Pro-Rata Rights

Pro-rata rights allow investors to add more funds to maintain ownership percentage rights following equity financing rounds. The investor will pay the new price versus the original price. These rights are an excellent way to keep strong investors motivated to move forward with their investment over the long term.

Most-Favored Nations Provision

Most-favored nations provisions (MFNs), also known as non-discrimination clauses, require startups to give the same privileges to all investors. For example, if convertible securities are issued to future investors at better terms, the previous investors will also receive those same terms.

For example, if you invest in a startup at a 20% discount and $3m valuation cap, and a future investor receives a 30% discount, you will automatically receive the 30% discount.

SAFE Agreement vs. Convertible Note

SAFE agreements are different from convertible notes. The former is a contractual agreement that could convert into equity in a future financing round, while the latter is short-term debt that converts into equity. However, they’re similar due to simplicity and flexibility, which is attractive to both investors and startups.

Here’s a closer look at SAFE agreements vs. convertible notes below:

Difference 1. Interest Rates and Maturity

In some circles, SAFE agreements are superior to convertible notes for the simple fact that they aren’t debt. As such, investors don’t have to worry about interest rates and maturity dates. In contrast, convertible notes involve both of these elements.

Many startups would prefer not to have debt on their balance sheet.

Difference 2. Structure

SAFEs also act as a standalone instrument that works in concert with other SAFE agreements purchased by new investors in the future at different dates and amounts. Convertible notes can be structured as a standalone or a series.

Difference 3. Risk and Tolerance

The risk and tolerance of SAFE agreements contrast convertible notes. Many investors are already familiar with convertibles notes since they have been around longer, and may feel unsure about SAFE agreements and their tax implications.

Difference 4. Options

The relative recency of SAFE agreements allows them to function as a standardized arrangement. In short, they’re more similarly structured from investment to investment. Convertible notes, on the other hand, come in many forms, which increases investing flexibility.

Which Is Better? SAFEs or Convertible Notes

The type of instrument you choose depends upon the startup and investor. Understanding the pros and cons of either one will help you understand why they’re used and, potentially, which one will work well for you. Venture capital lawyers can also become a wealth of information and insight to startups and investors alike.

Is a SAFE Agreement Debt or Equity?

SAFE agreements are neither debt nor equity. Instead, they’re the contractual rights to future equity. These rights are in exchange for early capital contributions invested into the startup. SAFE agreements allow investors to convert investments into equity during a priced round at some future point.

It’s also worth noting that SAFE agreements are advanced, high-risk instruments that may never turn into equity. They don’t accrue interest, nor are startups required to repay investors if they fail.

How Are SAFEs Accounted For?

Companies should generally account for SAFEs as a long-term liability, but may vary based on the circumstances. The reason for SAFE agreement accounting working in this manner is that they require startups to deliver an unknown number of future shares at an undisclosed price. As a result, more definitive numbers cannot be established performance or financial metrics come into fruition. It is always recommended to consult with an accountant and financial lawyer to ensure SAFE agreements are accurately represented on financial statements and tax returns.

The Security and Exchange Commission (SEC) also warns that investors should be careful when using SAFE agreements. While they can be structured simply, you should remember that they are not all created equally. In addition, triggering liquidity events may never happen either.

However, when a SAFE agreement goes smoothly, investors’ rights are generally greater than common stock shareholders. As such, SAFEs offer preferential rights, which are extremely attractive to experienced investors.

Get Help with SAFE Agreements

Due to the complexities associated with SAFE agreements, you must draft the terms and conditions accordingly. Once you sign the agreement, then a complete deal is in effect. Securities lawyers possess a strong command of finance law and a wide range of experiences with startups. Ensure you seek their legal counsel before offering or accepting a SAFE agreement. Post your project today to get help with a SAFE agreement.