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SAFEs: What are they? What are the positives and negatives of using them?

May 31, 2018
By: Robert Ksiazkiewicz

Six years after the passage of the Jumpstart Our Business Startups Act of 2012 (JOBS Act), SSTI continues to examine the impact that the legislation has had on startup capital. In previous weeks, SSTI has looked at Regulation A+ offerings and equity crowdfunding (also known as regulation crowdfunding or Reg CF). This week, we look at SAFEs (simple agreements for future equity), an early stage, equity agreement that has gained  popularity due, in part, to the JOBS Act streamlining companies’ ability to raise capital privately. A future story will focus on their use for TBED organizations.

At its core, a SAFE is an investment contract between a startup and an investor that gives the investor the right to receive equity from the company on certain triggering events. SAFEs are typically offered during the seed financing rounds as an alternative to the convertible note. This article will describe SAFEs in more detail and highlight positives/negatives from both the company and investor perspectives.

What are SAFEs?

Introduced in 2013 by Y Combinator and originally drafted by Carolynn Levy, a Y Combinator partner, the convertible agreement is intended to accomplish the same general goal as a convertible note, without being a debt instrument and in a more straightforward, quicker manner. In exchange for an investment, the investor can either receive a 2x or 1x payout option, or convert that value into equity shares after the company achieves a triggering event. Equity triggering events include future equity financing led by institutional investors such as a venture capital (VC) fund and/or a merge or acquisition (M&A) of the startup. If the company never reaches the triggering event, the investor is not issued shares or repayment.

While terms of a SAFE may differ between investors and companies, SAFEs are approximately five pages long and typically include several similar terms:

  • A 15 to 20 percent discount off the round price – the price of shares in the company determined by the round’s valuation;
  • A negotiable valuation cap may or may not be included;
  • No deadlines (or maturity dates) for conversion, thus the agreement remains outstanding indefinitely;
  • No minimum amount of money to be raised in the future equity round before being considered a triggering event;
  • Standard language for distribution preferences, anti-dilution mechanisms, conversion from preferred to common stock, protective provisions, etc.; and,
  • SAFE Preferred Stock have the same rights, privileges, preferences and obligations as Standard Preferred Stock.

SAFEs are considered an alternative to convertible notes for several reasons, including they are generally quicker/easy to negotiate, do not have an end date, and no accumulation of interest.

While only approximately 2 percent of all early stage deals are made using SAFEs, it is becoming more common among incubators, accelerators and serial ‘super angels.’ Although SAFEs became very popular in California shortly after its creation by Y Combinator, SAFEs have been slowly adopted by individual investors and instituitional investors in regions across the country due to concerns by both investors and startups.

Positives and negatives of SAFEs

While SAFEs offer advantages to convertible notes and other early stage investment agreement structures, many in the startup investment community remain skeptical.

SAFEs are usually considered to be very company friendly because:

  • There is a lot of flexibility for the startup due to limited pre-defined terms;
  • They are very straightforward;
  • There are no maturity dates;
  • The company doesn’t hold the debt properties of a convertible note;
  • The agreement structure offers the ability to quickly come to an agreement with multiple individual investors;
  • Low legal costs to the standardized structures and limited terms to negotiate; and,
  • Typically, an easy conversion once the triggering event happens.

One major drawback for a startup is that it must become incorporated to offer a SAFE. Most startups, however, are formed as LLCs. This creates some additional legal costs for the startup.  

Another drawback for startup founders is that dilution doesn’t show up on the company’s cap table until the notes actually convert. This can lead to more dilution than the founder may expect at the time of conversion. This is of special concern for companies with multiple discount rates and valuations caps via SAFEs. Many VC investors and institutional investors also may pass on a deal because they do not want to have to deal with addressing multiple investors with different discount rates and valuations caps.

For investors, the primary benefits of SAFEs are centered on their straightforward and cost-effective nature.  Especially for companies with significant near-term investment potential, investors may prefer SAFEs over convertible notes and other investment structures because it allows the company to access the capital needed to move operations forward. It also reduces many hurdles because of its simple structure and limited pre-determined terms. Multiple SAFEs can be “stacked” by the startup agreeing to similarly worded SAFEs to a pool of investors during a seed capital investment round.

The lack of a maturity date, however, can be very negative for investors including economic development-focused organizations because there is no guarantee of any return on investment (ROI). If the company does not have a triggering event and/or survives on its own, the investor will never receive a return on their investment. SAFEs may also create little incentive for the company to work toward a triggering event because there is no penalty for missing an investment maturity date as there would be in a convertible note.

The Security Exchange Commission (SEC) and both individual and institutional investors also have concerns that SAFEs may not provide investor protections, have standard rights in a default situation, offer controls or oversight by the investor, or include many other investor rights common to convertible notes and other structures. Many investors also contend that convertible notes have been standardized to the point that they are just as quick and easy to negotiate as SAFEs. Similar to SAFEs, these standardized convertible notes only requite the startup and investor to negotiate the discount rate and valuation cap while offering more protections/oversight for the investor.

 

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