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Startups need to raise money, but it’s nearly impossible to attract new investors without discuss valuation and performance indicator data. While this may seem like a latent problem without a solution, the good news is that there’s an investment instrument, known as a SAFE agreement, that solves it.
Find out everything you need to know about SAFE agreements through the article below.
What Is A SAFE Agreement?
SAFE agreements, also known as simple agreements for future equity and SAFE notes, are financial agreements that startups use to raise seed financing capital and similar to a warrant. They’re an alternative to convertible notes and KISS notes and were introduced by Y Combinator in 2013. The terms and conditions of SAFE agreements determine the relationship between the startup and investor regarding equity rights for triggering liquidity events.
Triggering Liquidity Event
A ‘triggering liquidity event’ in a SAFE agreement refers to an event that causes the conversion of a SAFE into equity. These can include:
- Equity Financing. If a startup raises capital by selling preferred shares to investors, the financing round can trigger the SAFE agreement holders’ investment to convert into equity, often at the discount rate or valuation cap.
- Liquidity Event. A liquidity event is a broad category, but can include things like the sale of a company or an Initial Public Offering (IPO). If these happen, the SAFE agreement holders’ investment converts into equity before the transaction.
- Dissolution or Bankruptcy. If the company goes out of business, dissolves, or files bankruptcy, the SAFE agreement holders may have rights to remaining assets of the company and can cause the investment to convert into equity.
Here’s an article that discusses SAFE agreements.
How Do SAFE Agreements Work?
It’s challenging to value a startup at the beginning of its inception. SAFE agreements solve this problem. They allow you to delay valuation until a future date while still having the opportunity to invest or raise capital.
Once the company grows, it will likely raise additional capital and subsequently increase in value. It’s this result that investors are trying to achieve. The SAFE agreement converts into company shares when new investors do priced rounds in the future.
Example of How Safe Agreements Work
Let’s say you invest $25,000 through a SAFE agreement. Since assigning a valuation to early stage companies is almost meaningless, the startup will leverage its SAFE agreement to find new investors to defer valuation to a future event. The investors are simply buying the right to equity in the future, when the startup has more traction and performance data that would allow an institutional investor to properly value the startup. At this point, your $25,000 would convert into equity relative to the valuation of the priced round. Early investors typically get a benefit from taking a risk, which includes discounts and valuation caps.
This article also discusses what you need to know about SAFE Agreements.
SAFE Note Templates
Important Terms in a SAFE Agreement
SAFE agreements are powerful investing tools. However, there are important terms in SAFE Agreements that you must understand. The five terms we’ll consider in this article include discounts, valuation caps, pre-money or post-money, pro-rata rights, and the most favored nations provision.
Discount
SAFE agreements can include a discount. The discount is used if the SAFE investor money converts in future financing rounds and the valuation was at or below the valuation cap. For example, a 20% discount rate means an investors money would buy shares at a $8m valuation if the priced round was $10m (20% discount).
Valuation Cap
Valuation caps are another common term in SAFE agreements that investors can use to obtain a more favorable price per share in the future by setting a maximum convertible price. They reward investors for taking on additional risk.
As an example, suppose a startup is raising capital at a $10m valuation and the SAFE investor had a valuation cap of $5m. In that case, SAFE investors shares convert at the valuation cap ($5m) despite the startup has just been valued at a $10m valuation. SAFE investors are typically happy if the valuation cap comes into play.
Pre-Money or Post-Money
Pre-money or post-money refers to valuation measurements that help investors and founders understand how much a company is worth. It’s one of the most essential terms in a SAFE agreement. Pre-money means the valuation is before new investor money. Post-money means the valuation includes the capital raised in that round.
Here is an article about pre-money and post-money valuation.
Pro-Rata Rights
Pro-rata rights allow investors to add more funds to maintain ownership percentage rights following equity financing rounds. The investor will pay the new price versus the original price. These rights are an excellent way to keep strong investors motivated to move forward with their investment over the long term.
Most-Favored Nations Provision
Most-favored nations provisions (MFNs), also known as non-discrimination clauses, require startups to give the same privileges to all investors. For example, if convertible securities are issued to future investors at better terms, the previous investors will also receive those same terms.
For example, if you invest in a startup at a 20% discount and $3m valuation cap, and a future investor receives a 30% discount, you will automatically receive the 30% discount.
SAFE Agreement vs. Convertible Note
SAFE agreements are different from convertible notes. The former is a contractual agreement that could convert into equity in a future financing round, while the latter is short-term debt that converts into equity. However, they’re similar due to simplicity and flexibility, which is attractive to both investors and startups.
Here’s a closer look at SAFE agreements vs. convertible notes below:
Difference 1. Interest Rates and Maturity
In some circles, SAFE agreements are superior to convertible notes for the simple fact that they aren’t debt. As such, investors don’t have to worry about interest rates and maturity dates. In contrast, convertible notes involve both of these elements.
Many startups would prefer not to have debt on their balance sheet.
Difference 2. Structure
SAFEs also act as a standalone instrument that works in concert with other SAFE agreements purchased by new investors in the future at different dates and amounts. Convertible notes can be structured as a standalone or a series.
Difference 3. Risk and Tolerance
The risk and tolerance of SAFE agreements contrast convertible notes. Many investors are already familiar with convertibles notes since they have been around longer, and may feel unsure about SAFE agreements and their tax implications.
Difference 4. Options
The relative recency of SAFE agreements allows them to function as a standardized arrangement. In short, they’re more similarly structured from investment to investment. Convertible notes, on the other hand, come in many forms, which increases investing flexibility.
Which Is Better? SAFEs or Convertible Notes
The type of instrument you choose depends upon the startup and investor. Understanding the pros and cons of either one will help you understand why they’re used and, potentially, which one will work well for you. Venture capital lawyers can also become a wealth of information and insight to startups and investors alike.
Is a SAFE Agreement Debt or Equity?
SAFE agreements are neither debt nor equity. Instead, they’re the contractual rights to future equity. These rights are in exchange for early capital contributions invested into the startup. SAFE agreements allow investors to convert investments into equity during a priced round at some future point.
It’s also worth noting that SAFE agreements are advanced, high-risk instruments that may never turn into equity. They don’t accrue interest, nor are startups required to repay investors if they fail.
How Are SAFEs Accounted For?
Companies should generally account for SAFEs as a long-term liability, but may vary based on the circumstances. The reason for SAFE agreement accounting working in this manner is that they require startups to deliver an unknown number of future shares at an undisclosed price. As a result, more definitive numbers cannot be established performance or financial metrics come into fruition. It is always recommended to consult with an accountant and financial lawyer to ensure SAFE agreements are accurately represented on financial statements and tax returns.
The Security and Exchange Commission (SEC) also warns that investors should be careful when using SAFE agreements. While they can be structured simply, you should remember that they are not all created equally. In addition, triggering liquidity events may never happen either.
However, when a SAFE agreement goes smoothly, investors’ rights are generally greater than common stock shareholders. As such, SAFEs offer preferential rights, which are extremely attractive to experienced investors.
Get Help with SAFE Agreements
Due to the complexities associated with SAFE agreements, you must draft the terms and conditions accordingly. Once you sign the agreement, then a complete deal is in effect. Securities lawyers possess a strong command of finance law and a wide range of experiences with startups. Ensure you seek their legal counsel before offering or accepting a SAFE agreement. Post your project today to get help with a SAFE agreement.
Meet some of our SAFE Agreement Lawyers
Bryan B.
Experienced attorney and tax analyst with a history of working in the government and private industry. Skilled in Public Speaking, Contract Law, Corporate Governance, and Contract Negotiation. Strong professional graduate from Penn State Law.
Keidi C.
Keidi S. Carrington brings a wealth of legal knowledge and business experience in the financial services area with a particular focus on investment management. She is a former securities examiner at the United States Securities & Exchange Commission (SEC) and Associate Counsel at State Street Bank & Trust and has consulted for various investment houses and private investment entities. Her work has included developing a mutual fund that invested in equity securities of listed real estate investment trusts (REITs) and other listed real estate companies; establishing private equity and hedge funds that help clients raise capital by preparing offering materials, negotiating with prospective investors, preparing partnership and LLC operating agreements and advising on and documenting management arrangements; advising on the establishment of Initial Coin Offerings (ICOs/Token Offerings) and counseling SEC registered and state investment advisers regarding organizational structure and compliance. Ms. Carrington is a graduate of Johns Hopkins University with a B.A. in International Relations. She earned her Juris Doctorate from New England Law | Boston and her LL.M. in Banking and Financial Law from Boston University School of Law. She is admitted to practice in Massachusetts and New York. Currently, her practice focuses on assisting investors, start-ups, small and mid-size businesses with their legal needs in the areas of corporate and securities law.
Jason H.
Jason has been providing legal insight and business expertise since 2001. He is admitted to both the Virginia Bar and the Texas State Bar, and also proud of his membership to the Fellowship of Ministers and Churches. Having served many people, companies and organizations with legal and business needs, his peers and clients know him to be a high-performing and skilled attorney who genuinely cares about his clients. In addition to being a trusted legal advisor, he is a keen business advisor for executive leadership and senior leadership teams on corporate legal and regulatory matters. His personal mission is to take a genuine interest in his clients, and serve as a primary resource to them.
Matt B.
Matt practices law in the areas of commercial finance, corporate law and residential and commerical real estate (with a particular emphasis on retail shopping centers and office buildings). He has extensive experience in negotiating and structuring complex commercial loan, asset acquisition, asset disposition and real estate transactions. Matt additionally works on various general matters for clients such as forming LLCs and corporations, preparing various LLC and corporation documents and drafting and reviewing various types of contracts and agreements for clients and providing advice regarding same. Matt provides clients with extensive and timely communication on their matters and ensures that his clients are well represented and highly satisfied with their legal representation and the work product provided. Matt offers all potential clients a free initial consultation to discuss their legal matters prior to engaging his firm to represent them. Prior to opening his law firm Matt worked for many years in the New York City office of a large international law firm where he counseled large multi-national businesses, financial institutions, investment groups and individuals on highly sophisticated business, financial and real estate transactions. Matt provides his clients with diligent legal representation on their matters with a very personal approach.
September 7, 2023
D. Cassie B.
Cassie has spent more than a decade handling all aspects of litigation, focusing on divorce, family law, Personal Injury Protection (PIP) claims, contracts, fraudulent insurance claims, and bodily injury claims. She has worked at small boutique law firms, in house for major insurance carriers, and most recently as a partner at a large nationwide practice. She has served as lead counsel on thousands of cases statewide. Cassie now contributes this knowledge and experience for the benefit of her clients. She is zealous about obtaining the best financial outcome for her clients and supporting them while they navigate the difficult terrain of family law, contracts, insurance claims, and personal injuries.
September 8, 2023
Gina O.
see resume.
September 8, 2023
Matthew K.
I am a business organization, IP and data privacy attorney with over 19 years of experience, as well as a Certified Information Privacy Professional. I have successfully worked in both the public and private sectors, contribute to academia in all of my areas of expertise, and hold leadership positions with key organizations in the legal industry. Some sample agreements/documents with which I have drafting and negotiating expertise include: Business Formation Agreements Privacy Policies Information Security Policies and Documentation Master Services Agreements Joint Venture Agreements Non-Disclosure & Confidentiality Agreements Software Licensing Agreements Employment Contracts Distribution Agreements Equipment Lease Agreements All forms of Entertainment Legal Agreements M&A Due Diligence Checklists EDiscovery Protocols Legal Hold Documentation Outsourcing Agreements Real Estate Purchase & Sale Agreements Subcontracting Agreements Software Development Agreements for Mobile Apps IP Licensing and Royality Agreements Loan Agreements & Documentation Insurance Policy Reviews Employee Handbooks & Policies E-Commerce Terms & Conditions Sponsorship Agreements All forms of Digital Creator Agreements Subscription Agreements & Policies Agency Agreements Supply Chain & Logistics Agreements And more...
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