The Simple Agreement for Future Equity (SAFE) has been gaining popularity  as a result of its use by seed accelerators such as Y Combinator in the US, and NACO in Canada. It has allowed startups to greatly reduce the complexity and length of negotiations with angels and other seed-stage investors when raising capital, attracting the interest of startup founders everywhere. If you’re one of these founders and looking to use a SAFE, you might have some questions, and hopefully the list below will help highlight some important things to consider before using a SAFE.

If this is your first time hearing about the SAFE, or you’re looking for a bit of a refresher, check out the annotated Y Combinator SAFE and NACO SAFE templates on our site by logging in to your Clausehound account.

 

Does Your SAFE Correspond With Your Articles of Incorporation?

The templates linked above both contemplate issuing preferred shares to the investor. It’s important to note that these SAFE templates assume that the company’s Articles of Incorporation provide for a class of preferred shares. They do not consider what the company has actually issued or is able to issue based on its own Articles. Thus, it is important for the company to make sure that they have created a class of “preferred shares” within their Articles, otherwise the SAFE note may be referring to non-existent shares that can never be issued.

Furthermore the company should consider what type of shares they are willing to issue – they may desire to issue only common shares.

When Does Your SAFE Convert?

Typically, a subsequent equity financing, often involving a sale of preferred shares, provides the trigger. A notable caveat for investors is that the company might never decide to issue preferred shares, meaning they could sit on the SAFE note which would never convert, and the investor would never see any equity!

Other trigger options could be the issuance of some minimum amount of financing. For example, for a company that has raised $1 million in total to date, the raising of an additional 1 million would be significant and could be added to the definition to also trigger a conversion.

How Much Equity Are You Giving Away?

A pre-money valuation is the valuation of the company before any investment money comes in, and it’s also used for the purpose of the conversion formula:

%Equity = (Purchase Amount / Pre-money Valuation)

At the time of negotiating the SAFE, only the Purchase Amount can be determined. Taking time to determine the valuation (the most complicated part of the investment process) would undermine the entire point of the SAFE. As a result, the SAFE treats pre-money valuation as a yet-to-be-determined x-value. If the investor buys the SAFE at $100 000, and the pre-money valuation in a subsequent equity financing is $2 million, the investor has got 5% (1/20) of the shares issued in that financing. If the pre-money valuation is $500 000, the investor has 20% (1/5).

Of course, most investors would normally be extremely uncomfortable investing in this scenario. They don’t know the total size of the equity pie, so there’s no way of determining how big their slice will be (or what they’ll have to pay in terms of the conversion price). That’s where the Valuation Cap comes in!

How Do the Valuation Cap, and Discount Rate Affect the SAFE?

It helps to think of the Valuation Cap as a tripwire. There is a chance that in a subsequent round of equity financing, the company’s pre-money valuation may greatly exceed what the SAFE purchaser contemplated at the time of the purchase. Logically, this means the denominator in the ratio above will become much bigger relative to the Purchase Amount, meaning a smaller stake in the company.

To protect against dilution of their share in such a circumstance, the investor will request a Valuation Cap which, if exceeded, entitles them to receive preferred shares with a better liquidation preference and conversion rate, as well as priority on dividends; this is often defined in the SAFE as “SAFE Preferred Stock.” This is contrasted with “Standard Preferred Stock.” In this manner, the effect of the larger than expected pre-money valuation is offset.

Sometimes an investor will also request a Discount Rate which applies to the price per share of the Standard Preferred Stock. The SAFE holder can then opt to use the Valuation Cap or the Discount Rate, depending on what will leave them with the greatest number of shares.

A SAFE does not need to feature both a Valuation Cap and Discount Rate, and most SAFEs only feature the former, but some could feature both or only the Discount Rate.

Does the SAFE holder get Pro-Rata Rights?

Pro-rata rights, in simple terms, allow an investor to participate in subsequent rounds of equity financing to maintain their percentage ownership of the company. SAFE notes often confer those rights to SAFE holders by way of pre-emptive rights. However, by default there is no dollar limit on this right. Anyone who invests even a nominal amount in your company would have pro rata rights. Consider adding a dollar limit if you don’t want every investor to have these rights.

Take-aways

  • SAFEs are understandably unattractive to many investors – they do not get shares until the SAFE converts, meaning they do not have shareholder rights, nor do they receive interest on their money.
  • Since investors are investing without the comfort of a priced round or a concrete valuation, the SAFE must provide concessions in the form of a Valuation Cap and/or a Discount Rate.
  • Cross-reference the SAFE with your Articles of Incorporation to ensure you are going to be issuing shares your company can issue.
  • Carefully define when the SAFE will convert into equity, and ensure it is fair to the investor (i.e. won’t leave them stuck without the ability to convert their SAFE into shares) to encourage them to invest.

 

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This article is provided for informational purposes only and does not create a lawyer-client relationship with the reader. It is not legal advice and should not be regarded as such. Any reliance on the information is solely at the reader’s own risk. Clausehound.com is a legal tool geared towards entrepreneurs, early-stage businesses and small businesses alike to help draft legal documents to make businesses more productive. Clausehound offers a $10 per month DIY Legal Library which hosts tens of thousands of legal clauses, contracts, articles, lawyer commentaries and instructional videos. Find Clausehound.com where you see this logo.

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