To help early-stage companies grow, founders will typically need initial “seed” capital, which can come from family and friends or high-net-worth “angel” investors. In exchange for accepting seed capital, early-stage companies may want to consider offering initial investors a Simple Agreement for Future Equity (SAFE), which is a straightforward and easily-negotiated convertible instrument that will provide the investor a right to future equity in the company.
What is a SAFE?
A SAFE is a convertible instrument that an early-stage company can provide to its initial investors in exchange for an investment of seed capital. A SAFE automatically converts into an equity ownership interest in the company (e.g., stock) upon the first to occur of a future equity raise or the sale of the company. The amount of equity the SAFE holder will receive on conversion is based on the value of the company determined in the future equity raise or sale, subject to any negotiated discount in the SAFE.
SAFEs share many similarities to convertible notes. However, the two key differences between a SAFE and a convertible note – a SAFE does not have a maturity date and does not accrue interest – make SAFEs much simpler and easier to negotiate (i.e., less expensive to implement). Additionally, SAFEs typically require less documentation than convertible notes, which again makes them a less expensive alternative.
Why Choose a SAFE?
In exchange for seed capital, early stage companies typically prefer to offer investors equity in the company. The challenge with offering equity, however, is that it can be a very expensive proposition. It is especially difficult to value an early-stage company, particularly an intellectual property-reliant company, so there can be substantial disagreement on valuation. The time to negotiate the value of the company (including any related appraisal or accounting fees), plus the legal fees to negotiate the preferential treatment of the investors (e.g., preferred returns, registration rights, buy-sell rights, etc.), are often more than the early-stage company or the investors want to expend when time and money can be better used to grow the company.
In this case, convertible instruments such as SAFEs can be indispensable. A SAFE defers the valuation process to the subsequent valuation done in connection with the company’s future arms-length equity financing (e.g., a financing in excess of $1 million to $5 million) or in connection with the future sale of the company.
What are the major components of a SAFE?
The sole major negotiable component of a SAFE is the discount the SAFE holder receives on the price per share of the company’s stock in connection with the future equity financing or sale of the company. There are typically two kinds of discounts that may be provided in a SAFE: a discount rate and a valuation cap. A discount rate is a percentage discount (typically between 10% and 30%) of the equity price offered in connection with the future equity financing or sale of the company. A valuation cap is a limit on the valuation of the company that is used when determining the equity price per share in connection with the equity financing or sale of the company. The amount of a valuation cap is completely dependent on a particular company, but caps between $3 million and $10 million are not unusual. The SAFE can include either or both the discount rate and valuation cap. If the SAFE includes both, an investor would be able to utilize whichever of the two provides the greatest value at the time of conversion. These examples show how these discounts are calculated in connection with a future equity financing and the sale of a company.
Another provision sometimes included in a SAFE, but only if an investor has significant leverage, is a most-favorable nations (MFN) clause. A MFN provision ensures that the SAFE holder gets the benefit of any more favorable valuation caps or discounts that are negotiated by the company with future SAFE holders. Typically, a MFN clause can only be used once, unless the future SAFE also includes the provision.
Why is a SAFE a better alternative to a more traditional Convertible Note?
For early-stage companies, a SAFE may be preferable to a convertible note for a number of reasons. The two primary benefits are: (i) that a SAFE has no maturity date and (ii) that a SAFE does not accrue interest on the invested amount. These two aspects can be an issue for early-stage companies, particularly if a convertible note does not convert to equity before the maturity date. At maturity, a convertible note holder is in a position to demand repayment of the original investment, plus the accrued interest, which an early-stage company likely does not have or would prefer to reinvest in the company. Alternatively, a convertible note holder may try to renegotiate for more favorable terms in exchange for extending the maturity date. Either result is unfavorable for a company and can result in additional legal fees. Moreover, the documentation for a convertible note is substantially more complex than a SAFE, costing a company time and money at a point when those resources are particularly precious.
What Are the Drawbacks to a SAFE?
From an investor’s perspective, utilizing a SAFE may lead to a situation where it is unable to convert the SAFE until the ultimate sale of the company. While this is a less likely outcome, if the company never conducts a future round of financing, then the SAFE would stay outstanding until the company is sold or dissolved.
Another potential drawback is the current uncertainty of a SAFE’s tax treatment by the IRS. As a relatively new instrument, the IRS has not made a definitive determination as to whether a SAFE should be treated as debt or equity. While a SAFE lacks the typical requirements of debt (i.e., maturity date and interest), because it is only an option to receive equity in the future, it is unclear whether the IRS will characterize a SAFE as something other than equity.
While a variety of factors contribute to the decision on investment structure for an early-stage company, a SAFE can be an advantageous alternative for any early-stage company that is raising capital. Because a SAFE has the potential to cost considerably less than the alternatives, and because it still provides investors the upside protection they seek, it is an investment vehicle that both the early-stage company and most sophisticated investors will want to consider.
To discuss whether a SAFE may be an appropriate structure for your early-stage company or if you have questions, please contact Chris Wright (firstname.lastname@example.org; 610-341-1026) or Michael Lutz (email@example.com; 610-341-1025).