A SAFE agreement, short for a “simple agreement for future equity”, is a financial instrument used by companies to raise capital from investors. A SAFE agreement allows investors to invest without setting a valuation at the time of funding. In exchange, investors receive the right to future equity in the company.
SAFE Agreements streamline the investment process by deferring valuation discussions, which is especially beneficial for new startup companies who need capital. This arrangement benefits both parties, allowing startups to secure funding quickly while providing investors with potential future ownership stakes.
What Should I Look for in a SAFE Agreement?
It is important to fully review the SAFE Agreement before agreeing to the terms and entering into the contract. When evaluating a SAFE agreement, look for the following key provisions and considerations:
- Conversion trigger The conditions that trigger the conversion of the SAFE agreement into equity issued to the investor. Common triggers include a qualified financing round, a liquidity event, or a specified maturity date.
- Valuation cap A valuation cap sets a maximum valuation at which the SAFE agreement will convert into equity. This protects investors from potential future high valuations.
- Discount rate A SAFE agreement should include a discount rate. This allows investors to purchase equity at a lower price than future investors in the same round.
- Maturity date Many SAFE agreements include a maturity date. This is the date after which the SAFE agreement may convert into equity without a specific trigger. This provision protects the investor in the event the specific trigger event does not occur.
- Conversion terms The terms under which the SAFE agreement converts into equity. The contract should specify the type of equity, for example, preferred shares, and any potential adjustments to the conversion terms.
- Dilution protection Provisions that protect an investor’s investment from reducing in value in the case of subsequent funding rounds or stock issuances.
- Rights and information The rights granted to SAFE agreement holders like access to company information, updates, and participation in certain company decisions.
- Exit event considerations Provisions regarding how the SAFE agreement will convert or be redeemed in the event of an acquisition, IPO, or other exit scenario.
- Legal and regulatory compliance The SAFE agreement should comply with all applicable laws and regulations that govern these financial instruments.
- Negotiation flexibility Whether the agreement allows the parties to negotiate specific terms to better align with your investment goals.
- Company's financial health It is important to assess the company’s financial health and growth potential. The investment’s success will depend on how well the company performs.
- Founder-friendly terms Be aware of any overly burdensome terms that may unfairly favor the company or other investors over your interests.
- Tax implications Understand the potential tax implications of your investment and conversion.
- Exit strategy alignment Ensure the terms of the SAFE agreement align with your own exit strategy and investment objectives.
SAFE agreements can vary in terms of complexity and investor protection. It is always recommended to hire a lawyer to review the instrument before agreeing to the terms. Thoroughly reviewing and understanding the terms will help you make an informed investment decision.
Is a SAFE Agreement Binding?
Yes, a SAFE agreement is a legally binding contract. When an investor and a company sign a SAFE agreement, both parties agree to be bound by the terms and conditions outlined in the agreement. For this reason, it is highly recommended that both parties obtain legal counsel before entering into the agreement.
A lawyer will review the SAFE agreement to ensure that the terms represent the best interest of their client, and the contract follows all applicable laws and regulations that govern these types of financial instruments. A lawyer will also explain any complex legal terms to ensure their client fully understands their rights and obligations under the SAFE agreement.
What is the Discount Rate for a SAFE Agreement?
A discount rate in a SAFE agreement is the predetermined percentage that allows the investor to purchase shares of the startup's equity at a lower price than the price paid by future investors in a later financing round. Discounted rates provide the investor with an incentive to invest at an earlier stage and help to mitigate any risk the investor is taking.
The discount rate is negotiated between the investor and the startup and is specified in the SAFE agreement. It is important for investors to carefully consider the discount rate because it can significantly impact their potential returns and the overall benefit of the investment.
What is the Valuation Cap in a SAFE Agreement?
A valuation cap is the maximum pre-money valuation at which the investor's investment will convert into equity. Conversion to equity requires a specified triggering event like a subsequent financing round or a liquidity event. The valuation cap protects early investors by ensuring that their investment converts into equity at a favorable price.
The valuation cap will be included in the SAFE agreement and can impact an investor’s potential returns. For this reason, these terms need to be reviewed and carefully considered prior to entering the agreement.
What Happens if a SAFE Agreement Never Converts?
If a SAFE agreement never converts, that means that the specified triggering events for conversion did not occur within the agreed-upon timeframe. If these triggers do not happen, the SAFE agreement will remain outstanding, and the investor will not be issued equity.
If a SAFE agreement does not convert, one of the following scenarios may occur:
- 1. Maturity date Many SAFE agreements include a maturity date, which is a point in the future when the SAFE automatically converts into equity even if the triggering events have not occurred.
- 2. Negotiation or amendments If the company and the investor want to continue their relationship, they may be able to amend the original SAFE agreement. The parties can negotiate an extended timeframe for conversion triggers, revising the terms, or add a maturity date to ensure that the investor's interests are protected.
- 3. Redemption or repayment Some SAFE agreements include provisions that allow the company to redeem or repay the invested amount to the investor if conversion triggers are not met and there is no maturity date in the agreement. These provisions vary and may involve returning the original investment amount or an adjusted amount based on the terms of the agreement.
- 4. No conversion or repayment If the conversion triggers are not met and there is not a specified maturity date conversion, the investor's investment may not result in equity ownership and the investor may not receive any repayment.
When a SAFE agreement fails to convert, the investor does not receive equity for their investment. Careful review and negotiation of a SAFE agreement is essential to protect the investor’s goals and interests and avoid this type of scenario.
When an investor hires a lawyer to review the SAFE agreement, the lawyer will ensure that the agreement includes protections for the investor like conversion triggers, maturity dates, and the ability to negotiate amendments.
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