Playing It SAFE

With an increase in the number of people who are opting to become entrepreneurs, there is a need to seek funding for their startup companies. Instead of obtaining loans from financial institutions, what is becoming increasingly popular is for entrepreneurs to make use of what is known as a Simple Agreement for Future Equity, “SAFE” for short.

A SAFE is a legally binding agreement between a company and its investors in terms of which the parties agree to the exchange of cash investments now in return for future equity in the company.

While there are a multitude of benefits to these types of agreements, there are disadvantages to SAFEs which one must be mindful of before concluding same.

In this article, we explore both the benefits (pros) and disadvantages (cons) of SAFEs.

Benefits (Pros)

As the name suggests, a key feature of SAFEs is that they are intended to be simple. There are fewer variables to negotiate which saves time and allows the transaction to be concluded in a more expedient and efficient manner. This also allows the parties to save on associated costs in relation to the transaction.

SAFEs also require less coordination than other types of financing as the company or founder is able close with an investor as soon as both parties are ready to sign and make the funds available to the company.

In addition, SAFEs are viewed as a more founder-friendly alternative to convertible notes. This is largely due to the fact that SAFEs impose no obligation on the founders to repay the investment if the SAFE is not converted into equity.

There is no interest that accrues on the investment amount which means investors are not entitled to interest on their investments. They are instead only entitled to a right to convert their SAFEs into equity at a lower price than the investors in the in the subsequent funding.

This is also a benefit for investors as they acquire a right to convert their SAFEs into equity at a lower price than new or subsequent investors.

A SAFE has no maturity date and it remains outstanding indefinitely until such time that a conversion event occurs.

Once a conversion event occurs, the investor’s shares or equity will have the exact preferences, rights and restrictions as the preferred shares of the new investors in the equity financing.

SAFEs provide for the option of a discount. This discount is used as a mechanism to address the higher risk of investment that SAFE investors take on when investing in an early-stage start-up. It is a discount on the price per share paid by new investors in the equity financing and may range anywhere between 5% and 30%. The higher the discount rate, the more equity SAFE investors would receive for their investment.

Disadvantages (Cons)

A disadvantage of SAFEs is that being a SAFE investor does not entitle one to the rights of a shareholder in the absence of a conversion event. Instead, SAFE investors are entitled to a future equity only if a conversion event occurs. If the conversion event does not occur, this may result in the SAFE investor losing its entire investment as SAFEs impose no obligation on founders to repay the investment if the SAFE does not convert into equity. SAFEs are therefore not suitable for investors who expect repayment of an investment should it fail.

If the valuation cap, being the highest valuation at which the amount invested in the SAFE would be converted into equity, is too low, founders risk relinquishing too much equity to the SAFE investors and diluting their own equity in the process.

Similarly, if an investor contributes an amount of that he or she expects to be worth a particular stake in the company and the company surpasses that goal and becomes more successful than anticipated, the investor’s percentage of equity may end up being far lower than expected.

Conclusion

While the pros to/of SAFEs appear to outweigh the cons, founders and investors alike must exercise caution when concluding SAFEs and ensure that their respective interests are safeguarded. If the terms of the SAFE are not clearly defined and understood by both parties, they may encounter unpleasant surprises.

"Please note that the above article has been authored for information purposes only and does not constitute legal advice. The reader is therefore advised to consult with an attorney where necessary."