SAFE Fundraising – Know the Pros and Cons
Early-stage companies have several ways of raising funds, from convertible notes to angel equity investments. When early-stage companies raise capital, we often hear of extraordinary legal costs and delays associated with establishing valuation and completing documentation.
Entrepreneurs/early-stage companies often need to raise capital in a short timeframe and prefer a streamlined process. Setting the valuation of an early-stage enterprise can be a challenge. Selling equity at an early stage risk significant dilution to the entrepreneur/founders.
Enter the SAFE – Simple Agreement for Future Equity. The SAFE was created by Y Combinator in 2013 to simplify and streamline the fundraising process for early-stage companies. A SAFE provides a template that mitigates legal costs and delays valuation discussions until the company is further established.
But is a SAFE a good deal for the investor or company?
Understanding SAFE as a template with specific conversion terms
A SAFE is an agreement by which an investor provides cash today in exchange for an equity stake in the future at an undetermined valuation. The valuation and conversion are triggered by subsequent funding rounds, typically a Series A, institutional financing, or a sale of the company.
Interestingly, at closing, a SAFE investor has no stake in the company and generally has no legal rights beyond the opportunity for their funding to convert into equity in the future. The investor has no legal claims in bankruptcy or otherwise and no say on the company’s board or in its operations. The investor has no formal stake in the company and simply has a contractual right to convert today’s investment into equity in the future. The SAFE may never convert to equity if the company never raises another round. This “no strings attached” feature, combined with the efficiency of the documentation process, is attractive to issuers/the company.
SAFE’s primary negotiated terms in more detail
SAFEs include a relatively simple legal document and require negotiation on two primary points, among others:
1. The discount the investor receives relative to the next financing round; and/or
2. The valuation cap
The conversion terms detail how the SAFE investment converts into equity in the future.
Like a convertible note, SAFE investors agree to invest today at a predetermined discount to the next financing round. If the investor and issuer agree to a 25% discount, funds invested today would convert into equity in the future at a 25% discount to the next financing round’s valuation. For example, if a company had a SAFE in place and the next round of funding was a Series A, the SAFE investor would get 75 cents per share for every dollar per share the Series A investor received.
A valuation cap is a different way to protect the investor. A SAFE investor might agree that today’s funds will be converted subject to a cap on the next round’s valuation. If the future valuation is significantly higher than the cap, the SAFE investor is rewarded with a better price per share. Valuation caps come in two flavors: pre-money and post-money valuation.
SAFE agreements can have either/or, or both (discounts and valuation caps). If a SAFE investment includes both a discount and a valuation cap, then the investor converts using the more favorable methodology.
The pros and cons of a SAFE
Like any funding structure, the SAFE poses advantages and disadvantages to both the investor and the issuer/company. These pros and cons can be summarized as follows:
SAFEs from the investor’s point of view
For the investor, the simplicity of the investment structure is a blessing and a curse. Legal fees can be modest, but so are the protections. Like all early-stage investments, SAFEs can be especially risky because when you provide the funding, you don’t end up owning anything. In the event of a liquidation or wind-down, you may get nothing if the SAFE hasn’t already converted.
SAFE’s may include other provisions, such as protection against future dilution, repurchase rights, dissolution rights, and limited voting rights.
Valuing early-stage companies is particularly challenging. The conversion features can be beneficial, especially if you negotiate both a discount and a valuation cap. A SAFE can be a great way to help a young company that you believe can grow quickly. You may benefit as an investor by getting in early. Getting a preferential ownership stake relative to the institutional investor can be appealing.
SAFEs from the company’s point of view
For the company, the short-term benefits of a SAFE issuance are clear: you can raise necessary capital today through an efficient process and defer the valuation discussion. There’s no short-term dilution, and you’re not taking on any debt. You generally have limited obligations to anyone in the short term until you raise more money in the future. The entrepreneur/founding team retains control.
However, a SAFE can be expensive if the company doesn’t meet its projections. Even a modest discount or reasonable valuation cap can be much more expensive in the future than you contemplated.
Conclusion
A SAFE issuance is an efficient way for an early-stage company to raise funds and allows the issuer to retain significant control. Documentation is straightforward, valuation is deferred until the next financing round, and the investment process is streamlined.
For the investor, there is always a high risk when considering an early-stage investment.
For the company, even the simple terms of a SAFE – the discount and/or valuation cap – can have a meaningful, unexpected impact on future dilution for a founder if not properly analyzed. Entrepreneurs/founders need to carefully consider the scenarios and understand what they’re giving up for the efficiency of using a SAFE.
We’ve run numerous scenarios to help companies understand the potential risks and benefits of using a SAFE. Please reach out to us with any questions or comments.
Resources:
https://www.parsalaw.com/what-startups-should-know-about-simple-agreement-for-future-equity
https://www.ycombinator.com/documents/
https://www.finra.org/investors/insights/safe-securities
https://www.dlapiper.com/en/canada/insights/publications/2020/07/demystifying-safes/
https://betakit.com/a-safe-model-for-early-stage-investing-in-canada/
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