Although preferred stock or convertible notes are still the predominate choice for start-ups in seed and early-state financings, a relatively new financing instrument called a Simple Agreement for Future Equity (“SAFE”) has gained traction in the start-up ecosystem. A SAFE shares many characteristics with a convertible note, but is not technically a debt instrument. It is an investment contract that grants an investor the right to receive equity in the future following a “triggering event” (e.g., equity financing or sale of the company). Whether you are a start-up looking for financing, advising start-up clients during formation, or considering an investment in a start-up, a SAFE is worth looking into.
A SAFE is different from a convertible note in a few distinct ways:
- Most SAFEs are drafted to avoid being considered debt, and thus are generally not subject to state and federal lending laws. This can help lower transaction costs and legal expenses, a crucial consideration for start-ups.
- SAFEs do not include a maturity date or accrue interest. SAFE investors also do not hold a claim on the start-up’s assets; as such, there is no risk that the investor will call in a promissory note, causing a solvency crisis.
- Finally, the primary terms to be negotiated between the investor and the start-up are the valuation cap and, if used, the discount rate. This helps streamline the negotiation process, which in turn may lead to faster funding and decreased costs.
The key terms of a SAFE are set forth below. It is important to note that not all SAFEs include each of these key terms, and many only include a valuation cap.
- The valuation cap represents the maximum valuation that will be used after a “triggering event” to calculate the SAFE’s conversion price. The SAFE investor will receive their equity at a per-share price that is, at most, calculated using the capped value, giving them an advantage over investors coming in at the higher valuation.
- A discount rate is not used in every SAFE, but when it is it provides SAFE investors with “down round” risk protection. In a down round, the SAFE will convert at the “down round” per share price multiplied by the discount rate.
- Preemptive rights grant the SAFE investor a contractual right to purchase equity shares (in addition to the shares issued on conversion of the SAFE) in future financings. It is critical for start-ups to weigh the need to use preemptive rights to secure current capital with the potential deterrence effect they may have on future capital.
- A most favored nation clause guarantees that, to the extent future investors receive more advantageous terms than the SAFE investors, the SAFE investors terms will be “bumped up” to the more advantageous terms. Like preemptive rights, the existence of this clause can negatively impact future financings.
While a SAFE’s upsides are compelling, there are some risks that founders and investors should carefully consider:
- While the lack of a maturity date grants peace of mind to start-ups, it can become a problem if the business does not reach a “triggering event.” Unless negotiated beforehand, a SAFE remains outstanding indefinitely, which may frustrate SAFE investors.
- The tax treatment of SAFEs remains unclear. Until definitive tax guidance is available, all SAFEs are subject to very fact-dependent tax treatment, which may concern investors.
- As discussed above, certain SAFE terms, in particular, preemptive rights and most-favored nation rights, may deter future sources of financing. We have seen situations where the existence of these rights prevented future financings from closing because the future investors did not want to contend with them and the SAFE investors would not waive them.
A SAFE may help you, your client, or your investment partners streamline early-stage financings. But given their relative novelty, using them will likely require some education for all concerned parties. And to ensure they live up to their name, it is important to talk through your specific scenario with an experienced attorney before committing to a SAFE.
See: Startup Seed Financing Instruments: Convertible Notes and SAFEs, Practical Law, Practice Note W-000-5245. This blog post is provided for educational and informational purposes only. This information is not legal advice and no attorney-client relationship is formed. If you need legal advice, please consult a qualified attorney in your area.
Joe and Brett practice in the business law group at Briggs and Morgan, P.A., focusing primarily on mergers and acquisitions and venture capital. If you have any questions regarding SAFEs, please do not hesitate to email Joe at firstname.lastname@example.org or Brett at email@example.com.