What is a SAFE Agreement?
A Simple Agreement for Future Equity (SAFE) is used between a company and an investor. It allows startups to reduce the complexity and length of negotiations with seed-stage investors when raising capital. A SAFE functions like a convertible note, however is not a debt instrument. Rather, a SAFE is a contractual right to future equity.
Investors invest their money into a company using a SAFE. In exchange, the investor receives a right to purchase stock in a future equity round, subject to certain conditions set beforehand in the SAFE.
Initiating a Friends & Family Fundraise
It can be challenging for an early-stage company to persuade formal investors to contribute to the first round of funding. As a result, it is common for startups in their early stages to leverage their existing relationships. This phase of fundraising is called the Friends and Family round.
To start, consider the valuation of your company. This can be difficult because at this early stage, startups are likely not generating any revenue. Due to thelack of revenue, it is difficult to project into the future and provide an accurate valuation of the company. There are agencies that can provide companies with a pre-seed valuation. This approach can add legitimacy to a company’s valuation since it will not be self-proclaimed.
Second, determine how much money you are needing to raise. When initiating a friends and family round, note that the purpose is to kick-start your company. As such, do not estimate the maximum amount of funding you can generate. Rather, think strategically. For example, develop a six-month plan and determine how much it will cost to buy what you need (ex. inventory, assets, financing for early employees). When you develop a plan like this, it can be easier to request additional funding if the business is progressing according to the plan.
Third, build a business plan. Develop concepts and define goals that will communicate a clear path for your first six to twelve months. Detail how you plan to utilize the initial funds and state any risks involved. In addition, you can compare how your business differs from competitors.
Fourth, make the pitch. You can produce a PowerPoint or similar presentation that will clearly communicate your vision, how you are going to achieve your goals, and how you will measure the progress at each stage along the way.
In a friends and family round, there are three common ways that you can receive funding. The first is a loan (a planned repayment), the second is a gift (no requirement to pay back the money), and the third is equity (contributors become investors and later shareholders). This article will focus on the equity option that is governed by a Simple Agreement for Future Equity (SAFE).
Equity Investments with Friends & Family
When your friends and family are investing in your company in exchange for equity, it is your responsibility to detail the risks involved. As a founder, you are at risk of injuring your relationships if your early-stage investors are not properly informed and educated. As a result, it is a founder’s obligation to provide basic investor education. For example, elucidate when your early investors will be able to convert their SAFE into stock. Often, a subsequent equity financing involving a sale of preferred shares provides the trigger.
Beyond raising money, it is important to acknowledge that the investors signing a SAFE will become a part of the company as shareholders. As a result, there are various future stipulations to consider.
Structuring the Deal
- Don’t Over-Dilute Equity
When onboarding investors through early equity shares, determining a cap on equity is critical. Setting a cap on equity will help to ensure that you do not dilute the number of shares available. This is important if you plan on securing formal investors in future fundraising rounds. When you plan for a cap on equity, later rounds of investment will be easier to secure, because the equity will not be diluted early on.
Furthermore, equity is a key motivator for both early-stage employees and future investors. As a result, it is important to consider this fact when adding early passive stakeholders.
- Develop Term Sheets
Term sheets are a necessary element to future fundraising. They are useful for two reasons. First, they help to ensure that you do not over-dilute equity. Second, the term sheet will outline the risks involved in the investment, which is important in the event that investors do not realize any return on their money.
- Plan your fundraising goals
Although a company may be unable to accurately predict how much money it will raise during the next round, having a clear idea of fundraising goals is essential. For instance, a company will want to avoid raising an excessive amount of money through SAFEs. If they fail to do so, it can result in an over-dilution of Series A investors when those SAFEs eventually convert into equity. To prevent this, planning in advance and saving a specified amount of equity for your next round of fundraising will help ensure that future investors stay interested and motivated.
Once you have secured friends and/or family members as investors, you can begin the process to close the deal.
- A SAFE allows start-ups to receive financing from investors. In exchange for money, an investor receives a right to purchase stock in a future equity round.
- While structuring a SAFE, the most important consideration for a company is to determine a cap on equity to avoid over-diluting shares.
- Prior to issuing a SAFE, a start-up will need to first 1) determine the valuation of the company 2) plan its fundraising goal 3) build a business plan, and 4)
- make a pitch.
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 is a specialized software agency that builds document and knowledge tools for product design teams that support educators and trainers, governments and their citizens, law firms and legal teams, and large or small businesses.
Edited by: Rajah Lehal