Several relatively new hybrid instruments have been invented to aid the funding of businesses, particularly start-ups. One of these is an instrument called SAFE, which was introduced by Y Combinator in 2013.
The word “SAFE” stands for “Simple Agreement for Future Equity.”
It refers to a contract between an investor and a company which involves the investor making an upfront payment of the purchase price for an equity which he or she would be receiving in a future priced round. The aim is to offer a clearer, better and simpler alternative to the startups who were obligated to pay interest on to the customary convertible promissory notes that functioned more like as a debt instrument.
Below, we would be considering the several advantages and disadvantages of SAFEs with respect to companies and investors.
Pros and Cons for a Company
Companies are likely to find SAFEs friendly and beneficial.
- SAFEs offer a simple and effective option for financing. The form used by these agreements have fewer variables and potentially enables expediency and speed in reaching agreements about terms.
- Discussion over valuation postponed to when there is more visibility of the company success chances.
- With less to negotiate, the time spent on negotiation is reduced and transactional and legal costs are saved.
- Interest on the principal amount is not required.
- SAFEs also do not require that the company makes repayments.
- An investor receives equity exclusively in the instance of the SAFE’’s conversion trigger achieving pursuant to a subsequent qualified financing by the company, or in the event of M&A or IPO.
- These agreements contrast to convertible promissory notes as regards the presence of a deadline for conversion. Companies therefore are afforded increased flexibility regarding timing for a true equity round.
- Considering the likely need for a more widespread review and negotiation as some investors may not feel comfortable with the standard SAFE provisions, there may be no less of a difference between the associated fees of a SAFE financing and that of a convertible promissory note offering.
- SAFEs may not be acceptable to more refined investors who have higher bargaining power. In this case, other financing options such as a convertible promissory note may instead be offered by the company.
- The Investor receives the same type of equity and similar rights, as those investors who took the time to review the Company, (usually) invested substantial amounts in a priced financing (triggering the SAFE conversion), and negotiated their terms throughout the investment process.
Pros and Cons for an Investor
Investors, particularly early stage investors, have more to consider when choosing SAFE as an acceptable investment tool. There are select situations in which using SAFE is a sensible investment decision for an investor, considering that an investment being returned or converted into equity is uncertain.
- Akin to convertible promissory notes, SAFEs provide investors the benefit of increased investment value with a discount and/or valuation cap.
- The simplicity of the agreement allows investors to save time and transactional fees.
- Depending on the terms of the SAFE, the investor would usually receive a discount or capped valuation, compared to the next priced financing.
- The Investor will receive the same type of equity and similar rights, as those investors who took the time to review the Company, and negotiated their terms throughout the investment process.
- SAFE has seniority over ordinary shares/common stock, in the event of liquidation.
- With the lack of assurance of equity ownership, the bulk of the risk is borne by the investors.
- Without being able to declare a default under SAFE, investors are not afforded any leverage to compel a repayment or a conversion on favorable terms in the situation of the company’s poor performance.
Types of SAFEs available:
- Valuation Cap, no Discount – states the maximum valuation the SAFE can be converted based on.
- Discount, no Valuation Cap – the Investor gets a discount on the next priced round price.
- Valuation Cap and Discount – the Investor gets the better between – the discount on the next priced round price, or a capped valuation.
- MFN, no Valuation Cap, no Discount – the Investor’s terms of financing would be the same as the next investor’s terms.
…How can Investors customize their SAFEs?
- Include a gradually increasing discount rate, based on the period between execution and conversion (functions similarly to interest).
- “Qualified Financing” definition – make sure the financing is substantial, and the SAFE cannot be converted at a small financing where it is likely the terms of the financing were not properly negotiated by the lead investor.
- Beefed representations – include additional representations and warranties from the Company, with respect to liabilities, assets, IP, and alike.
- Information rights – request standard information rights – like management reports and other available information that can help you monitor your investment.
- Preemptive – request a preemptive rights letter – so you can participate in the next financing.
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