Beginner's Guide to Simple Agreement for Future Equity (SAFE)

In the early stages of your startup, determining the company's value can be challenging. If you exchange equity for funding at this stage, you might end up forgoing a significant portion of your ownership. To avoid this issue, convertible notes were introduced; however, these instruments soon proved to be complex and cumbersome.

Enter Simple Agreement for Future Equity (SAFE) - a streamlined alternative to convertible notes. A SAFE is a powerful tool that can help startups secure the funding they need without the complexities and potential drawbacks of traditional equity financing methods. By simplifying the fundraising process, it has become a popular choice among founders and investors.

In this blog, we will discuss the key facets of a SAFE agreement, explaining its meaning, features, types, benefits, challenges, and more.

What is a Simple Agreement for Future Equity (SAFE)?

A Simple Agreement for Future Equity (SAFE) is an investment instrument used by startups to raise capital without immediate valuation. It grants investors the right to convert their investment into equity at a future valuation, typically triggered by a subsequent funding round or acquisition.

This financial tool was introduced by Y Combinator, a renowned startup accelerator, in 2013 to simplify the process of early-stage fundraising. SAFEs quickly became a staple for both startups and early investors as they addressed the complexities associated with traditional equity financing or convertible notes. Due to their user-friendly nature, simplicity, and efficiency, their adoption increased within the Y Combinator community and subsequently expanded across the broader startup ecosystem.

Traditional equity financing often involves complex valuation negotiations, creating time-consuming hurdles for founders. Convertible notes, while intended to streamline this process, introduce their own complexities, such as interest rates and maturity dates. SAFEs emerged as an effective solution. Unlike convertible notes, SAFEs are equity-based, not debt-based, eliminating the concerns of interest and maturity. Investors receive shares at a future equity round under terms outlined in the SAFE agreement.

What Does a SAFE Agreement Include?

A SAFE agreement includes several key components, each designed to protect the interests of both the startup and the investor. Let's take a closer look at these elements:

• Valuation Cap: The valuation cap is a pre-agreed upon value that sets a maximum limit on the company valuation, at which the simple agreement for future equity will convert into equity. For example, if a SAFE has a valuation cap of $10 million, and your startup's next financing round values the company at $15 million, the SAFE investor's equity will be calculated based on the $10 million cap, not the $15 million valuation. 
• Discount Rate: The discount rate is a percentage that is subtracted from the price per share in the next financing round when the SAFE converts into equity. This means that SAFE investors get to purchase their shares at a lower price compared to other investors in that round. For instance, if the discount rate is 20%, and the price per share in the next round is $1, the SAFE investor would pay only $0.80 per share.
• Triggering Events: These are specific events that cause the SAFE to convert into equity. The most common triggering event is a priced equity financing round, where your company raises capital in exchange for issuing shares at a specific price. Other triggering events can include a change of control (such as a sale of your company) or an Initial Public Offering (IPO).
• Pro Rata Rights: Some SAFEs include a clause that gives investors the right, but not the obligation, to purchase additional shares in future financing rounds to maintain their percentage ownership in your company.
• Liquidation Preference: This is a clause that determines the payout order in case your company is sold or liquidated. Investors with a liquidation preference get paid before those without.

• Most Favored Nation (MFN) Clause: This clause ensures that investors receive the best possible terms in a SAFE. If you offer better terms to another investor in a subsequent SAFE, the Most Favored Nation Clause allows the original investor to adopt those better terms. 
• Exit Event: An Exit Event is a scenario (an acquisition or an Initial Public Offering (IPO)), that initiates the process of conversion of the SAFE into equity. When an Exit Event occurs, the investor's SAFE converts into shares of your company, giving the investor an ownership stake. 

How does a Simple Agreement for Future Equity work?

A SAFE can streamline the fundraising process for your startup, but how does it work in practice? Let's break down the mechanics of a SAFE from the investor's initial contribution to the conversion into equity at a future financing event.

1. Investment: An investor decides to invest in your startup and agrees to use a SAFE. This way, they essentially provide capital in exchange for the right to purchase equity in your company at a later date.
2. Agreement Terms: You and the investor agree on the terms of the SAFE, including a valuation cap and a discount rate.
3. Business Progress: Over the next few years, your startup progresses, developing its product, gaining customers, and increasing its value.
4. Qualifying Round: This is typically a priced equity round, such as a Series A round, where you raise capital by issuing shares at a specific price.
5. Trigger Event: A specific event, such as a subsequent financing round, triggers the conversion of the SAFE into equity. This could be a priced equity round where your company raises additional capital by issuing shares.
6. SAFE Conversion:
   • Valuation Cap: If your company's valuation at the next financing round exceeds the valuation cap, the investor's equity is calculated based on the cap. 
   • Conversion with Discount Rate: The investor gets a discount on the price per share in the next financing round. 
7. Equity Ownership: The SAFE converts into equity, and the investor now owns shares in your company. The number of shares they receive depends on the SAFE terms and the valuation of your company at the time of conversion.

Example of SAFEs Working

Here's an example to better understand how SAFE works in practice.

Let's consider that you are the founder of a tech startup, and you have caught the interest of an angel investor who is willing to invest $100,000 in your company. After some discussions, you both agree to use a SAFE with a valuation cap of $1 million and a discount rate of 20%.

Now, let's say your company does exceptionally well, and you secure a Series A financing round at a $5 million valuation. Here is how the SAFE would convert into equity:

• With the valuation cap: Despite the $5 million valuation, the investor's equity would be calculated as if the company was valued at $1 million. So, if the price per share at a $1 million valuation is $0.50, the investor would get 200,000 shares ($100,000 / $0.50) for their investment, which would be 20% of the company ($1 million / $5 million).
• With the discount rate: If the price per share at the $5 million valuation is $1, the investor would get the shares at a 20% discount, i.e., at $0.80 per share. So, they would get 125,000 shares ($100,000 / $0.80) for their investment, which would be 12.5% of the company ($1 million / $5 million).

Types of SAFEs

There are two main types of SAFEs that you can consider when raising early-stage financing: Pre-Money SAFEs and Post-Money SAFEs. Each type has its own unique characteristics and implications for founders and investors.

Pre-Money SAFEs

A Pre-Money SAFE is an agreement that converts to equity based on your company's valuation before any new financing is added. This type of SAFE can be more favorable for investors as it may result in a larger ownership stake. For example, if an investor contributes $100,000 through a Pre-Money SAFE with a valuation cap of $1 million, and your company's valuation at the next financing round is $2 million. Then, the investor's SAFE would convert as if the company was valued at $1 million. This means the investor would receive a larger share of equity for their initial investment.

Post-Money SAFEs

A Post-Money SAFE, on the other hand, accounts for the total valuation of your company after the new financing is included. This provides more predictable outcomes for both you and your investors by clarifying the impacts of dilution. For instance, if an investor contributes $100,000 through a Post-Money SAFE with a valuation cap of $1 million, and your company's valuation at the next financing round is $2 million. Then, the investor's SAFE would convert based on a $1 million valuation plus the amount of the new financing. This means the investor would receive a smaller share of equity compared to a Pre-Money SAFE, but the dilution impacts for all parties would be clearer.

Benefits and Challenges of SAFE

Using a SAFE can offer several advantages for your startup; however, like any financial instrument, it also comes with its own set of challenges. Let's analyze these benefits and challenges further.

Benefits of SAFE

• Simplified Legal Documentation: SAFEs offer a streamlined and standardized legal framework, reducing the need for lengthy negotiations and complex legal documents. This simplicity accelerates the fundraising process, allowing your team to focus more on growth and less on paperwork.
• Reduced Fundraising Costs: By simplifying the legal process, SAFEs significantly cut down the legal and administrative costs associated with fundraising. This is particularly beneficial for early-stage startups where every dollar saved can be reinvested into the business.
• Flexibility in Early-Stage Financing: SAFEs provide you with the flexibility to defer valuation discussions until a priced financing round. This allows you to accommodate various investor preferences and adapt to changing business conditions, making SAFEs a versatile tool for early-stage financing.
• Appeal to Angel Investors: The straightforward and flexible nature of SAFEs is attractive to angel investors. It allows them to support promising startups like yours', without getting entangled in complex equity negotiations, thereby encouraging more investments in early-stage ventures.

Challenges

• Future Dilution: When SAFEs convert to equity during later financing rounds, there is potential for significant dilution of ownership for founders and new investors. This means that your ownership stake in the company could decrease significantly, which might dilute your control over the startup.
• Uncertainty of Equity Conversion: Since SAFEs convert to equity at a future date, the exact amount of equity the investor will receive is unknown at the time of investment. This uncertainty can make it difficult for future investors to assess the potential return on their investment.
• Lack of Investor Protections: Compared to traditional equity investments, SAFEs lack certain investor protections until they convert. For instance, investors do not have immediate voting rights or dividends. While this simplifies the investment process, it also means that investors have less control and may not receive a return on their investment until a much later date.

Legal and Tax Considerations for SAFE

When considering a SAFE as a financing option for your startup, it is crucial to understand the legal and tax implications. Here are some key points to consider:

Legal Considerations

• Drafting and Executing SAFEs: The process of drafting and executing a SAFE requires careful attention to detail. It is important to clearly define the terms of the contractual agreement, such as the valuation cap, discount rate, and triggering events. Consulting with legal experts can ensure that your SAFE is compliant with relevant regulations and protects the interests of both your startup and the investor(s).
• Compliance with Regulations: SAFEs must comply with securities laws and other relevant regulations. This includes providing accurate and complete information to investors and filing necessary documents with regulatory authorities. 

Tax Considerations

• Capital Gains Tax: When a SAFE converts into equity, the investor may be subject to capital gains tax on any increase in the value of their investment. The tax treatment of a SAFE can affect the character of the gain on the disposition of the stock underlying the SAFE.
• Tax Treatment of Conversion Event: The conversion of a SAFE into equity can have tax implications for both the investor and your startup. For instance, if a SAFE is treated as stock for federal income tax purposes, then the holding period for purposes of Section 1202 would commence when the SAFE is issued, whether or not the SAFE converts into preferred stock.

How to Account for Simple Agreement for Future Equity?

When an investor contributes funds through a SAFE, these funds are added to your balance sheet as a debit to cash. Simultaneously, you would credit the SAFE notes line item on your balance sheet. This reflects the investor's right to future equity in your company. This entry will be recorded in your books as:

Debit: Cash $.......

Credit: SAFE Notes Payable $......

SAFEs are technically considered equity, not debt, despite some SAFEs incorporating debt-like terms. Therefore, they are accounted for as equity on the balance sheet. However, as your startup grows and its valuation changes, the potential equity that the SAFE represents may also change. It is important to update your financial records to reflect these changes regularly.

When a SAFE converts into equity, typically during a subsequent financing round, the SAFE note entry is removed from your balance sheet, and the amount is credited to preferred equity. This reflects the investor's new ownership stake in your startup company. 

Comparing SAFE with Other Early Round Financing Instruments

When considering early-stage financing options, you must understand the key differences between SAFE and other common instruments, such as convertible notes and equity financing. Let's compare these options against SAFEs:

• Convertible Notes: Convertible notes are a type of debt that converts into equity during a future financing round. Unlike SAFEs, convertible notes accrue interest and have a maturity date. This means that if the note has not been converted by the maturity date, the investor can ask for their money back or convert the note into equity. While convertible notes can be beneficial for startups that expect to raise a priced round quickly, they can also lead to higher dilution for founders due to the accrued interest.
• Equity Financing: Equity financing involves selling a stake in your company in exchange for capital. This requires setting a valuation for your company, which can be challenging in the early stages. Equity financing also typically involves complex legal documentation and longer negotiation processes compared to SAFEs. However, it provides immediate ownership and voting rights, which can be appealing to potential investors.

In contrast, SAFEs offer a streamlined and flexible approach to early-stage financing. They allow you to raise capital without setting a valuation upfront and without the complexities of traditional financing methods. However, SAFEs also come with their own set of challenges, such as the potential for significant dilution and the uncertainty of equity conversion. 

When choosing between these financing instruments, consider your startup's specific circumstances, fundraising goals, and investor preferences. Each option has its pros and cons, and what works best will depend on your particular requirements.

Conclusion

Managing a Simple Agreement for Future Equity (SAFE) can be a challenge as there are several factors you must consider, such as valuation caps, discount rates, and potential future dilution. As a startup founder, you need to navigate these challenges while focusing on growing your business.

This is where we, at Qapita, come in. We are committed to simplifying the fundraising process and managing equity for startups. Our platform is rated as #1 in the Equity Management Software category by G2, affirming our expertise in the domain. We offer a comprehensive solution for managing ownership, an efficient equity workflow management, and a structured marketplace to offer liquidity to stakeholders. We are trusted by over 2,000+ companies and 300,000 employee-owners.

Whether you are considering a SAFE for your next financing round or looking for a reliable platform to manage your startup's equity, we are here to help. Get in touch with our experts to learn more.