Introduction
Startups often find it hard to raise funds, though it is critical to their growth. A lack of track record, uncertain revenue streams, and limited collateral limit their access to traditional funding methods. These challenges also hinder investors and founders from agreeing on a realistic valuation. To escape these challenges, startups are adopting innovative funding options. Crowdfunding, Simple Agreements for Future Equity (“SAFEs”) and Keep It Simple Securities (“KISSs”) are alternative funding options tailored to early-stage startups. By using these options, they can raise funds with greater ease, speed, and flexibility.
This article explores SAFEs, their elements, benefits, and risks. It also highlights some factors to consider before using them.
What is a SAFE?
A SAFE is a contract granting an investor the right to own a startup’s shares upon a future trigger event, at a price determined by agreed terms. YCombinator introduced the SAFE in 2013, and since then, many successful companies have used it during their early-stage funding. Airbnb, DoorDash, and Coinbase used SAFEs during their earliest funding rounds. Today, all YCombinator startups use them by default.
SAFEs are simpler, cheaper, and more flexible compared to traditional options. They also let parties defer both equity conversion and company valuation, which benefits early-stage startups.
Elements of a SAFE
SAFEs can be customized by the parties. However, they typically include the following elements:
- Terms of Conversion: These are the terms by which a SAFE investment converts into equity. They include the share type, conversion mechanism, and any other terms (if any).
- Investor Rights: A SAFE may, in addition to granting the basic right to future equity, provide other rights to an investor. Pro-rata rights are sometimes granted. These are anti-dilution rights that help maintain an investor’s percentage ownership. Pro-rata rights enable investors to acquire enough equity (at the current price) to maintain their share of ownership during subsequent funding rounds and liquidity events.
- Conversion Trigger: This refers to events that trigger the investment’s conversion to equity. An equity financing round or an initial public offering (IPO) may serve as trigger events.
- Valuation Cap: The maximum valuation at which the investment converts to equity. This is set by the parties and protects investors from dilution. It ensures investors get a good price if a startup’s value soars before the trigger event.
- Discount Rate: The percentage discount from the share price when the investment converts to equity. A high discount rate may entice investors.
It is important to note that some of the elements are optional. Only the right to future equity, terms of conversion, and trigger events are essential.
Benefits of SAFEs
SAFEs have unique benefits. Some of these benefits are:
- Simplicity: SAFEs are short, easy to understand, and light on legalese. Their streamlined processes also make them easy to create and execute.
- Flexibility: SAFEs encourage parties to freely negotiate terms like valuation caps, discounts, and investor rights. This makes them suitable for various investors, startups, and circumstances.
- Delayed Dilution: Unlike VCs and angel investors, SAFE investors defer receiving their equity until after a future trigger event. This delay gives founders more runway and control until the investment converts.
- Increased Investor Protection: By including investor-friendly provisions, SAFEs help startups attract more investors. Valuation caps, discounts, and other rights protect investors’ interests. They also signify a potential increase in future equity.
- No Interest or Repayment Obligations: Unlike debt or revenue-based funding, SAFE-funded startups have no interest or repayment obligations. This frees up their entire revenue to pursue rapid growth.
- Lower Legal Costs: SAFEs’ simple structure makes them cheaper to negotiate and execute. This can help startups save on legal fees.
- Speed: SAFEs’ streamlined negotiation and documentation expedite fundraising. This allows startups to secure funding faster compared to traditional methods.
- Aligned Interests: With SAFEs, higher future valuation means better funding for the startup and a better price per share for the investor. This aligns both parties’ interests, unlike with typical equity funding.
The key attraction of SAFEs is their simplicity and flexibility. Parties can tailor them to their needs and situations. They can also reach an agreement on key terms in a way that protects everyone’s interests.
Risks of Using SAFEs
SAFEs offer major benefits but also involve some risks. Some of these risks are:
- Uncertain Valuation: Parties to a SAFE do not agree on valuation at the time of investment. Also, SAFEs do not state the exact number of shares an investor will receive upon conversion. This may make it hard to determine the exact equity ownership before the SAFE converts.
- Lack of Control: SAFE investors have no shares, voting rights, or say in the company until conversion. This may discourage investors who prefer a hands-on approach.
- Dilution Risk: Although SAFEs include terms to protect investors, the risk of dilution always remains. Later funding rounds and valuation increases may reduce an investor’s percentage ownership. This is especially true if pro-rata rights are not granted.
- Complexity in Later Rounds: SAFEs can quickly pile up on a startup’s capitalization table. This makes managing conversions harder. Negotiations during later equity rounds can also become more complicated and time-consuming.
- Loss of Investment: The conversion of a SAFE into equity is contingent on the trigger event happening. Where a trigger event is highly unlikely, an investor may lose their investment.
- Not Universally Accepted: Although SAFEs have existed for a decade, they are yet to be well-accepted outside the United States (“US”). Many investors are more used to other instruments and may not understand or accept them.
Pre-Money and Post-Money SAFEs
SAFE critics have noted that they make it hard to keep track of a startup’s ownership and dilution. This is true, especially where multiple pre-money SAFEs are used.
The pre-money SAFE was the first type introduced, used for pre-seed funding, which was often relatively small amounts by a single investor. With time, however, more startups found the instrument useful and used it to raise funds from multiple investors. The valuation was deferred until the occurrence of a trigger event, even as more SAFEs were entered into by new investors, which further diluted the ownership of earlier investors.
The increase in the number of pre-money SAFEs significantly complicated the process of tracking company ownership and dilution.
Example:
Mr. Fury, an angel investor, invests $250,000 in Ultron Technologies using a SAFE with a 50% discount rate. Subsequently, Ultron Technologies raises additional funding of $500,000, $750,000, and $1,000,000 from Dr. Banner, Ms. Romanova, and Mr. Stark. Ultron Technologies’ valuation will be determined during its Series A funding round.
In the above scenario, each subsequent SAFE dilutes the ownership of earlier investors, leaving Mr. Fury, Dr. Banner, and Ms. Romanova with less ownership than Mr. Stark, the newest investor, when their investment converts to equity during Ultron Technologies’ Series A funding round.
As a result, Mr. Fury, whose investment is worth the same amount as Dr. Banner’s after factoring in his 50% discount, ends up with a smaller ownership stake. Both Fury and Banner hold significantly less than Mr. Stark’s share, as their ownership was diluted by subsequent investments. This discouraged investors from using SAFEs early on, in a bid to avoid being the first, and therefore, the most disadvantaged investor. Founders also shied away from them, as having multiple SAFEs exponentially complicated their capitalization table. This issue persisted until the post-money SAFE, introduced in 2018, addressed it.
The post-money SAFE includes all existing SAFEs in calculating a startup’s capitalization. This makes it easier to track ownership and dilution, giving investors more certainty about their eventual stake. Post-money SAFEs all convert together—usually right before the trigger event. This way, an earlier investor’s ownership is not diluted by subsequent SAFE investments. If post-money SAFEs were used in the above scenario, all SAFEs would convert with each investor’s ownership proportional to their investment, after factoring in discounts and valuation caps.
Factors to Consider Before Using SAFEs
SAFEs are a good method of raising funds but may not be suitable for some startups. Certain factors should be considered before choosing SAFEs, some of which are:
- Stage of the Startup: SAFEs delay valuation and allotment of shares until the trigger event occurs. This makes them best for early-stage startups that have not yet issued equity or been formally valued. Thus, they may be ill-suited for a startup in its later stages or one with some funding rounds. Using SAFEs also entails a loss of equity, which may not align with the company’s growth plans.
- Fundraising Needs and Goals: A startup’s funding needs or goals may be incompatible with the use of SAFEs. Founders may desire full ownership and may instead pursue loans if they have enough cash. In this case, SAFEs may be unnecessary or counterproductive.
- Investor Profile: While SAFEs may appeal to certain investors, they may not align with the profile of others. Deferred equity and lack of interest payments may reduce SAFE appeal to some investors. The possibility of having the investment sum tied up may also discourage others.
- Complexity vs. Simplicity: SAFEs become more complicated as they accumulate on a startup’s capitalization table. Parties should weigh simplicity and ease against the problems that may later arise.
- Conversion Triggers: Parties should choose the trigger event with care. This is because if it does not occur, an investor may not realize returns on their investment.
- Investor Relations: The use of SAFEs entails the risk of diluting an investor’s ownership with future funding rounds. This may affect the investor-founder relationship and the startup’s long-term investor strategy.
- Regulatory Considerations: Parties must pay attention to the legal and regulatory regime governing the use of SAFEs. This is because they may conflict with the laws of the parties’ jurisdiction.
- Balanced Provisions: SAFE-funded startups should strike a balance between investor protection and maintaining enough control. It is important to attract investors with favourable terms. Founders should, however, consider long-term implications. Discounts and pro-rata rights, especially, should not be granted lightly.
- Exit Strategy: Parties should consider the exit strategy before using a SAFE. This is important as SAFEs impact the company’s capitalization structure. Parties should discuss how SAFEs fit into their financing strategy and exit plans.
These are some of the factors that should guide the decision to adopt SAFEs as a fundraising option. Considering these factors helps parties structure SAFEs effectively. More importantly, it shows whether SAFEs are truly a suitable option.
Although SAFEs are subject to general contract law and securities regulations, they are not common outside the US.
As a result, there may be no specific guidelines or regulations governing them in your country. However, regulatory environments change over time. It is advisable to consult legal experts and regulatory authorities regarding their legal status and regulatory framework.
Conclusion
SAFEs offer major benefits over traditional forms of equity funding. They are also structured to fit the funding needs of most early-stage startups. Although SAFEs entail risks, may not suit every startup, and may come with regulatory constraints, there is no doubt that they are ideal for startups in need of a fast, simple, and flexible way of raising funds, without interest or repayment obligations and with deferred valuation negotiations. Startups that fit the bill should seriously consider SAFEs.
