How Do SAFEs Work?
During the early stages of a business venture, including many technology start-ups, there can be difficulty, on the part of both founders and investors, in assigning a reliable and realistic value to the company. This is due to a number of factors, including the limited history and track record of the startup as well as the unknown future of its business prospects and growth trajectory. This is where a ‘SAFE’, or Simple Agreement for Future Equity, comes in, to postpone the valuation decision until a later time.
What is a SAFE?
A SAFE is a convertible security instrument, in the nature of ‘quasi-equity’ (neither debt, nor true equity), that converts the SAFE holder’s investment into equity of the company, in the future, upon the occurrence of a certain triggering event, which, usually, is the company’s first priced (e.g., properly valuated) financing round. This means that the SAFE investor does not receive any actual equity in the company immediately when entering into a SAFE. Rather, at the time of the next financing round, the SAFE will convert into equity of the company, taking into account any early-stage incentives (i.e., valuation caps and/or discount rates, as further discussed below), relative to the price paid by the new investors.
WHAT ARE THE INCENTIVES OF A SAFE?
For the SAFE holder’s early investment in the Company, SAFEs typically provide the holder with incentives, relative to the priced round investors, either in the form of a valuation cap and/or a discount rate depending on the structure of the SAFE. These incentives allow the SAFE holder to obtain a better price per share than a later investor, which is appropriate, given that, generally, they are perceived to be taking a greater risk by investing in a speculative venture at an earlier stage. A discount rate gives the SAFE holder, upon the SAFE converting into equity, a reduced price per share—typically a 10% – 25% discount, as compared to the price per share paid by the priced round investors. For example, if the financed round price per share is $1.00 per share, then the SAFE investors with a discount rate of 10% will convert their investment into stock at $0.90 per share, upon the consummation of the financing (the ‘triggering event’).
Additionally, a SAFE may contain a valuation cap which is the maximum valuation at which a SAFE will convert into equity in the priced financing round. In other words, if the company ends up raising money in its next priced round at a valuation above the valuation cap, then the SAFE investor nevertheless gets to convert at a share price equivalent to the valuation cap. So, the SAFE holder receives a more favorable price per share than the new investors; again, for taking a greater risk as an earlier investor, and, therefore, being entitled to certain ‘locked-in’ upside in the conversion event.
FUNDRAISING WITH SAFEs
Fundraising with SAFEs can be a great alternative to conventional debt financing or the uncertainty of an early equity round that is improperly priced, and should be considered by any early stage company who is trying to raise money in a fast, flexible, and appealing way to investors without having to complete a formal company valuation.
Josh Slovin, a business transactional attorney, focuses on providing legal counsel to his clients on a variety of corporate and transactional matters, including initial formation, corporate governance, mergers and acquisitions and capital raising.