SAFEs (Simple Agreements for Future Equity) have emerged as one financial instrument startups may choose to utilize when raising capital. Initially developed by Y Combinator in 2013 as an alternative to convertible notes, a SAFE investment provides an option for startups to secure their initial capital without the immediate complexities of a priced equity round. In this blog, learn more about SAFEs, how they are used, and key considerations for investors.

SAFEs Explained

A SAFE is a contractual agreement between an investor and a startup that provides the investor with the right to receive company equity at a future date, most often contingent on a specific trigger event occurring. Unlike convertible notes, SAFEs are not debt instruments. They do not accrue interest or have a maturity date. Instead, it is a security that represents a potential future ownership stake.

Some examples that may trigger the conversion of a SAFE into equity could include one of the following events:

• A priced equity financing round, such as a Series A
• A change of control, such as an acquisition of the company
• An initial public offering (IPO)

How SAFEs are Used

Simple Agreements for Future Equity are most often used in early-stage funding environments, and may even be offered as part of an equity crowdfunding round. The appeal of SAFEs can come from their simplicity and speed. The associated documentation is typically less complex than traditional equity financing agreements or convertible notes, which can allow startups to secure capital more quickly.

Benefits for Founders

For founders, SAFEs can offer some advantages:

• Deferred Valuation:  SAFEs allow valuations to be postponed until a later priced round, when more operational data and market traction may be available
• No Debt Obligation: Since SAFEs are not loans, startups are able to avoid the pressure debt, interest payments, and maturity dates
• Operational Focus: Fewer terms to discuss, contracts can be drawn up quickly, allows founders to dedicate more time to developing their product and business

Benefits for Investors

For investors, Simple Agreements for Future Equity can also provide some advantages:

• Access to Startups: SAFEs were developed to make it easier for startups to obtain their first capital and as such, investors are able to access innovative startups
• Favorable Conversion Terms: SAFEs often include mechanisms designed to reward those who take on early risk, which may be through a valuation cap or a discount rate
  • A Valuation Capsets a maximum company valuation at which the SAFE will convert into equity. If the startup’s valuation at the next funding round is higher than the cap, the investor’s SAFE converts as if the company was valued at the cap, which can result in more shares for the investor
  • A Discount Rateprovides the SAFE holder with a percentage discount on the price per share paid by investors in the subsequent priced round

Key Considerations for Investors

While SAFEs can offer a streamlined investment process, investors should be aware that they do carry specific risks and considerations.

Absence of Immediate Ownership and Rights

Since Simple Agreements for Future Equity do not equate to immediate company ownership, the investor is not an equity holder until the triggering event outlined in the investment documents occurs. If a company fails before a conversion event, SAFE investors may lose their entire investment, as they lack the shareholder status that a convertible note may provide.

Conversion Trigger Uncertainty

For SAFEs, conversion events are not guaranteed. They are completely reliant on the company going through a qualifying event. If a startup chooses to not pursue external funding, is not acquired, and doesn’t undergo an IPO, the SAFE investor may never receive equity in the startup.

Dilution and Cap Table Impact

Simple Agreements for Future Equity impact a startup’s cap table and existing shareholders when the shares convert to equity after a qualifying event. When this conversion occurs and new shares are issued to SAFE holders, typically new investors are added to the cap table and existing shareholders experience equity dilution.

Term Variability

Not all SAFEs are created equal. Different SAFEs may have different terms, different timelines, different qualifying events. Investors should carefully review the investment terms of the startup in which they are considering making an investment.

Final Thoughts

Simple Agreements for Future Equity can serve as a useful financial instrument for early-stage startups to use when raising capital. Their structure can provide speed and flexibility for both founders and investors in addition to other benefits. However, investors should carefully consider all limitations of SAFEs when conducting due diligence on a startup.

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Want to learn more about investing in startups? Check out the following MicroVentures blogs to learn more:

• Assessing a Startup’s Defensibility
• The AI Talent War: AI Acquisitions
• Assessing Overemphasized Startup Metrics
• Secondaries and Tenders: Private Market Liquidity

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The information presented here is for general informational purposes only and is not intended to be, nor should it be construed or used as, comprehensive offering documentation for any security, investment, tax or legal advice, a recommendation, or an offer to sell, or a solicitation of an offer to buy, an interest, directly or indirectly, in any company. Investing in both early-stage and later-stage companies carries a high degree of risk. A loss of an investor’s entire investment is possible, and no profit may be realized. Investors should be aware that these types of investments are illiquid and should anticipate holding until an exit occurs.