One of the biggest issues that a start-up usually faces… funding. A start-up needs support from investors to grow into the business world and the only way to invest in a start-up is to buy equity i.e., common, or preferred shares Thus, to raise funds it is important that the start-up gets investors, but to find investors for your start-up is not an easy task. It includes several stock documents which can be a hassle and can take tens of thousands of dollars in lawyers’ fees to negotiate the terms and issue. Now, that is definitely not the way a founder wants to spend their time and money getting started!
In the early stages of a business venture, founders and investors may have difficulty assigning a reliable and realistic value to the company. This is due to several factors, including the start-up’s limited history and track record, as well as the uncertain future of its business prospects and growth trajectory. That's where a Simple Agreement for Future Equity ("SAFE") comes in to defer the valuation decision until a later time.
Well, how about we learn more about what exactly a SAFE agreement is and how it works to protect start-ups from debt and increase their funds? Let us jump right into it!
What Are SAFE Agreements?
A Simple Agreement for Future Equity or SAFE is a legally binding agreement between the investor and founder of a start-up. To put it simply, the investors exchange their money in return for equity/shares in the start-up in the future.
For a long time, Convertible notes have been used as a shortcut for investing in early-stage start-ups. However, a convertible note is legally a loan, not equity, which creates some complications. It has a maturity date by which it must be converted into equity or repaid. (Ouch!) Worst of all, the loans are not eligible for the incredible tax benefits that the US government offers for investing in start-ups!
So, the start-up community was therefore ready for something more appropriate. SAFE agreements were introduced by Y-Combinator in 2013. The main purpose of start-ups using SAFE is to raise capital or earn more profits in their seed financing round which means, the early round where the start-up starts getting funds. This quickly gained popularity among start-ups and accelerators.
SAFE is assumed to be like convertible notes generally because they both provide future equity to investors and do not lead to debt for start-ups. Although, they are different from convertible notes since they do not have a fixed maturity date which convertible notes have. Thus, we can say that SAFE agreements are an alternative to convertible notes. SAFEs are easier, less expensive, and take less time to implement.
Later on, YC updated SAFE in 2018 with a new version known as SAFE v1.1 or “post-money SAFE” which became the most popular financial instrument for early-stage investing! It is seen as a better option as compared to other agreements since the SAFE agreement does not create debt for the start-up.
How Does A SAFE Agreement Work?
Start-ups require funding for both marketing and the hiring of new employees, but seeking new investors is extremely difficult without discussing valuation and performance indicator data. It can be very difficult to get investors to raise capital and would need a lot of money and time. While this may appear like a problem without a solution, the good news is that it can be resolved by an investment tool called SAFE. SAFE provides an opportunity for investors to delay their valuation to a future date while they can still invest and raise capital.
Through SAFEs, investors and start-ups come to an agreement to decide on valuation into the future when the start-up would have grown and would have got a chance to perform in the market. Here, start-ups and investors negotiate and decide a few things like valuation cap, discount, maturity date, and investment amount.
Once the investor and start-up agree on the terms and sign the SAFE, the investor puts an amount of money for investment in the start-up that is decided by the negotiation between the investor and start-up, the start-up tries to grow and raise its capital and increase in value, once the start-up achieves the capitals and maturity date arrives or an event triggers the conversion, the investment money gets converted into the shares of that company or start-up.
That's how SAFE helps investors and start-ups to get a platform to invest and grow respectively and does not lead to debt but a positive outcome for both start-ups and investors!
Key Terms To Focus On In a SAFE Agreement
SAFE agreements are great investing tools. Though, there are several crucial terms in the SAFE you must comprehend:
1. Valuation Cap
Valuation is like a tug of war, where the founders desire the highest valuation since they are looking to the future, whereas investors are more concerned with the present value and want the lowest valuation. This clause is another standard term in SAFE agreements that allow investors to specify a maximum convertible price in order to receive a better price per share in the future.
This is the maximum valuation at which a SAFE can convert to equity. This is a way for a SAFE investor to get a better price per share than later investors.
As an example, suppose the valuation cap is 5M and the start-up eventually raises money at a valuation of 10 million, the investor has the right to convert their SAFE at a share price equivalent to 5M. SAFE investors are usually happy when the valuation cap comes into play.
A valuation cap protects investors from unreasonably low equity conversion ratios during subsequent pricing rounds.
Sometimes a SAFE comes with a discount to woo early investors. The discount is used when the SAFE investor’s money is converted in future funding rounds and the valuation was at or below the valuation threshold. Such discounts are usually between 10-30%.
Let's say the SAFE is issued with a 20% discount. This means that if a SAFE investor invested $40,000 in a start-up whose share price at the time of the future investment will be $10, they would receive a share at a 20% discounted price, which is $8. This means he will get 5,000 shares (40,000/8) instead of 4,000.
3. Most-Favored Nations Provision
In some cases, a start-up takes funding from more than one investor before actually going to a favored equity funding round. To do this, he may also write two different SAFEs to different investors. Now, most-favored-nation (MFN) clauses, also known as non-discrimination clauses, require start-ups to give equal benefits to all investors.
Let's say you invest in a start-up at a 20% discount at a $3 million valuation cap, and if a prospective investor gets a 30% discount, you will automatically get a 30% discount.
4. Pre-Money or Post-Money
Pre-money or post-money describes valuation metrics that assist investors and founders in determining the value of a firm. This is one of the most important terms of the SAFE agreement. Pre-money means that the valuation is done before the money of the new investors. Post-money means that the valuation includes the capital raised in that round.
5. Pro-Rata Rights
Pro-rata gives an additional right to a SAFE investor to participate in the next round of financing to retain their ownership percentage in the company. These rights are a great way to keep strong investors motivated to move forward with their investments over the long term.
SAFE Vs. Convertible Note
The main difference between SAFE notes and convertible notes is S: "simple".
Like convertible notes, SAFE notes are designed to be converted into equity at a later date. However, the SAFE Notes contain several modifications that are intended to simplify the traditional convertible equity financing process.
It's safe to say that SAFEs are very friendly for both founder and investor in raising early-stage funding. SAFEs have no maturity dates, and this puts less pressure on founders, which sometimes means that the start-up beginning phases last longer than similar new companies that maintain utilizing obligations.