Understanding SAFEs: Simplified Agreements for Future Equity
Understanding SAFEs: Simplified Agreements for Future Equity
Simple Agreements for Future Equity (SAFEs) are becoming increasingly popular as a funding mechanism for startups and high-growth companies. However, despite their name, SAFEs are not necessarily simple. While they provide a quick way to raise capital, their terms can be complex, often leaving important decisions about equity and valuation for a later date.
Because minor changes to a SAFE’s terms can significantly impact a company’s capitalization table, founder dilution, and investor returns, it’s critical to consult legal advisors before issuing or purchasing a SAFE.
What is a SAFE?
A SAFE is a contract between a company and an investor where the investor provides funds in exchange for the right to:
Acquire equity in the company during a future financing event, or
Receive a cash payout if a liquidity event (e.g., sale or IPO) occurs before an equity financing.
SAFEs have no expiration date and terminate once they convert into equity or are paid out in cash. The conversion terms, often based on a valuation cap or a discount rate, define how the SAFE will translate into equity shares.
Though SAFEs are not technically equity, they often include terms that mimic preferred shares, offering investors certain protections and benefits.
Key Factors Affecting SAFE Conversion Price
The conversion price is the most critical term of any SAFE. It determines the number of shares an investor will receive when the SAFE converts. Unlike traditional fundraising, companies issuing SAFEs can defer setting a firm valuation until the next equity financing. The conversion price depends on several factors:
Valuation cap: The maximum valuation at which the SAFE converts.
Pre-money vs. post-money valuation cap: How the valuation cap is calculated in relation to existing equity.
Discount rate: A reduced price per share for SAFE holders compared to other investors.
Valuation Caps: Capped vs. No Cap
A valuation cap protects investors by setting a maximum price at which their SAFE can convert, potentially increasing the number of shares they receive:
If the company’s valuation exceeds the cap during the next financing, the SAFE converts at the cap, resulting in more shares.
If the valuation is below the cap, the SAFE converts at the actual valuation.
SAFEs without valuation caps typically include a discount, ensuring investors pay less per share than other participants in the next financing round.
Pre-Money vs. Post-Money Valuation Caps
The type of valuation cap significantly affects dilution:
Pre-Money Valuation Caps: Exclude shares from other SAFEs when calculating ownership, leading to more dilution for SAFE holders and less for founders.
Post-Money Valuation Caps: Include shares from existing SAFEs, ensuring a fixed ownership percentage for investors but causing more founder dilution.
Discounted Conversion Prices
SAFEs often include discounts (e.g., 10%–30%) on the next round’s share price. This ensures investors receive more shares than new equity investors. When combined with a valuation cap, SAFE holders may convert using the more favorable of the two terms.
Additional SAFE Terms to Consider
Most Favored Nation (MFN) Clauses: Protect SAFE holders by ensuring their terms automatically improve if better terms are offered to future investors.
Subscription Agreements: While not mandatory, companies should ensure they gather necessary investor information for compliance with securities laws.
Shareholders' Agreements: SAFEs often include provisions binding holders to future shareholder agreements, ensuring alignment with company governance.
Implications for Future Equity Financing
SAFEs typically convert into the most favorable class of shares issued during a future financing. Some SAFEs include protections, such as requiring a minimum fundraising threshold before conversion, to validate the company’s valuation.
Compliance with Canadian Securities Laws
While templates like those from Y Combinator can be helpful, they may not fully address the requirements of Canadian securities laws. Companies should tailor SAFEs to ensure compliance with local regulations, particularly when referencing U.S. legal frameworks.
Final Thoughts
SAFEs are a powerful tool for raising capital, but their terms can have significant implications for both founders and investors. Careful drafting, clear understanding of key provisions, and consultation with legal advisors are essential to maximizing the benefits of SAFEs while minimizing risks.