Is SAFE Financing Really Safe? What You Should Know as a Startup Founder or an Investor
In the past, startups were typically funded by equity offerings or by loans secured by convertible notes. But recently, it has become common for many startups
to offer their investors a hybrid type of security called a SAFE which stands for Simple Agreement for Future Equity.
A SAFE is an agreement between an investor and the company where the investor agrees to give the company an upfront investment. In exchange, the investor gets a future equity stake upon an agreed-upon future trigger event. Similar to a convertible note, a SAFE allows a company to raise capital while affording an investor a future stake in the company.
The Background of SAFE Financing
Developed in late 2013, SAFE fundraising was originally introduced by startup accelerator Y Combinator as a more convenient alternative to convertible notes for startup owners.
SAFE financing allows a company to raise funds, but without a formal valuation of the company. The investor buys a future stake in the company’s equity, but, unlike a convertible note, it is not considered debt. In fact, there is no interest rate or even maturity date. Instead, the SAFE converts to equity shares upon a set “triggering” event.
It may be helpful to understand the original purpose of SAFEs. SAFEs were designed primarily with silicon valley startups in mind. A SAFE enabled venture capitalists to invest in a startup more quickly and efficiently, with the focus on seizing an opportunity, not necessarily the safety of the investment. The simple mechanisms of SAFEs were designed for these fast-growing startups to attract quick capital from investors without the formalities.
While the first SAFES were designed for startups to raise small amounts of capital quickly, they are now being used more frequently to raise larger amounts of capital. Although they are becoming more commonplace, it’s important to understand SAFE financing from both a founder’s and an investor’s standpoint.
How SAFEs Work
Startups use SAFEs to raise capital by offering investors future equity shares at a pre-agreed trigger event in exchange for upfront capital. The investor is commonly offered a discount to the market value of shares when the SAFE does convert.
There are typically two types of events that will trigger a conversion: a qualifying round when the company issues shares to raise additional equity investment, or an exit event when a company lists on an exchange or when it sells its shares or assets. When a founder is using SAFE financing to raise capital, it is important to fully understand the variables, including
- What events will trigger the conversion
- What terms to consider when negotiating a SAFE
- What steps must be taken to trigger the conversion
- How shares that are issued to investors will be calculated
- How the conversion will effect dilution
The price at which the SAFE converts will be set out in its terms. Conversion price can be set based on a conversion discount, a valuation cap, or a combination of both. If the SAFE has both, the investor will get whichever affords the better share price.
For both founders and their investors, SAFEs can be simpler, faster, and more cost effective than Series Seed or Series A equity financing. But there are potential pros and cons that should be considered by both a founder and an investor.
Good For Companies and Founders
SAFEs tend to be very company-friendly and can be a good option for raising funds for a startup. For founders who are considering using SAFE fundraising, it can be easier and faster than typical convertible notes and equity fundraising. A SAFE is a simple format with fewer moving parts, so the terms can be negotiated and agreed upon easily and quickly. Because of this, there are less costs for transactional and legal costs for the founder.
There is no need to worry about interest payouts, repayment of the investment, maturity dates, or negotiating extensions. It will merely convert to equity shares at the given triggering point that is set out in the terms of the SAFE. Similar to convertible notes, SAFEs don’t give away any company control or ownership until conversion, so investors have no voting rights about company matters.
Although founders will typically like being able to raise capital without having to set a valuation, one major pitfall of SAFEs for founders is the potential effect it may have on capitalization and dilution as conversion will impact how much company they still own after the qualifying round is complete.
Are SAFEs Safe For Investors?
SAFEs, despite being company-friendly, are not as investor-friendly and may even be unsafe for early stage investors.
Although SAFEs do have the same advantages as convertible notes in the way of conversion discounts and/or valuation caps, there is no certainty of a conversion ever happening at all. Consequently, SAFE investors take on almost all of the risk of the investment.
In the case of a liquidation, SAFE investors are not entitled to any assets and have no leverage to force any repayment or favorable conversion if the company does not perform well. In addition, a SAFE will convert into SAFE preferred stock, not standard preferred stock, which has different liquidation preferences that should be considered when assessing it from an investor standpoint.
Getting Legal Advice
For anyone considering a SAFE, whether it is a company founder looking for funding or a potential investor, it’s important to understand the benefits and potential pitfalls considering the unique variables and context at play. Getting the guidance of a San Antonio business attorney that is experienced in startup financing can save you from making costly mistakes. Contact
the Law Offices of Ryan Reiffert, PLLC if you would like more information on SAFE financing for your business.