SAFE Agreements – the New Silicon Valley Standard
Getting the Initial Investment For Your Startup
Startups usually require a quick initial investment to get off the ground and continue to grow. This investment typically takes the form of a convertible note (“c-note”) – a loan. But the note is not your typical debt instrument. It does not require repayment. Instead, the investment “converts” into equity (i.e. stock) at a future financing round, usually the issuance of preferred stock. As a security, the c-note has specific legal requirements. It must be drafted in accordance with securities and other laws. In addition, it requires negotiation of terms and review to ensure lawful compliance. This can add up to thousands of dollars in legal fees and time spent negotiating rather than growing your company. However, a recent attempt to simplify the process has gained traction in California.
Over the past 5 years or so, SAFE (“Simple Agreement for Future Equity”) agreements has quickly become the standard investment agreement for Silicon Valley Startups. The idea is that the simplicity of the agreement streamlines the startup investment process – avoiding the time and legal fees of the c-note. The response has been encouraging. SAFEs have been embraced in California (but less in other parts of the country and the world). Hundreds of millions of dollars have now been invested using SAFEs. But whether to use a SAFE will depend on your startup’s particular needs and wants – it requires weighing the advantages and disadvantages.
Is the SAFE Right For Your Startup?
The advantage of a SAFE is what it is NOT. It’s not a debt instrument like the c-note. Thus, it does not require interest or a maturity date. This makes it very attractive to startups. They can focus on the health of their company rather than interest payments and maturity dates (and the threat of insolvency).
But some investors (and, for other reasons, startups) have taken issue with the lack of these provisions. After all, without a maturity date, a SAFE in theory may never have to convert. In addition, some investors see the absence of interest payments as perhaps encouraging a lack of motivation.
An additional advantage for the startup is what happens during a “change of control” (e.g. acquisition or IPO). The SAFE includes a payout or conversion to common stock should a change occurs. However, investors usually have more favorable payouts of 2x in convertible notes.
As for startup disadvantages, one prominent feature of the SAFE is the absence of a “qualifying transaction” provision. In a c-note, the conversion occurs after the qualified transaction– some minimum amount of equity financing. This leaves room for small friends and family investments in the startup without triggering the conversion. However, a SAFE does not have this. Any financing will trigger conversion automatically, whether the startup wants it or not.
Types of SAFEs
SAFEs, like c- notes, offer the flexibility of choosing among different types. There are four categories of SAFEs: (1) valuation cap; (2) discount; (3) both; and (4) “most favored nation” clause (MFN).
SAFEs include discounts and valuation caps as a way of rewarding the early investor. In a discount, when the SAFE converts to stock it will be at an agreed discount price – typically between 15 – 20%. A valuation cap, the most popular type, means the investment converts at a price not over the set cap. And lastly, a MFN clause means that a later investor will not have better terms than the initial investor.
Despite the streamlined appearance of the SAFE, there are still outstanding considerations and other legal details to be worked out. Although SAFEs are now effectively the standard in Silicon Valley, SAFE still has critics that are skeptical of simplifying a complicated process. Indeed, startups will likely have many questions regarding using a SAFE. And more importantly, questions they would never think to ask.
For example: Whether a SAFE requires a fair valuation report (409a valuation)? The 409a is required if your startup is offering employee stock options – it sets the future stock price. Failing to provide an accurate report could result in adverse tax consequences.
This is a good examples of why an inexperienced startup may need legal or tax advice during the investment process.