Simple Agreement for Future Equity (SAFE)

In the previous articles, we have discussed the concept of convertible notes. We have also seen the various pros and cons of convertible notes. However, convertible notes are not the only hybrid security that can be used by startups if they want to raise funds. A Silicon Valley-based startup accelerator named “Y Combinator” has created another type of financial instrument called “Simple Agreement for Future Equity” i.e. SAFE. This type of financial instrument is similar to convertible notes but also has some special features. In this article, we will have a closer look at the concept of SAFE as well as its real-life applications.

What is Simple Agreement for Future Equity (SAFE)?

Simple agreement for future equity (SAFE) can be considered to be similar to convertible debt in the sense that it is a financial instrument that allows investors to invest their money in a startup now in return for shares which will be provided at a later date. However, in the case of convertible debt, there are extensive negotiations between the startup founders and the investors. This is not the case when it comes to Simple agreements for future equity (SAFE). The SAFE instrument emphasizes the “simplicity” of the transaction. The standard agreement developed by Y Combinator for the SAFE instrument is a simple five-page agreement. The only two variables that need to be discussed are the amount of investment that the investor is willing to make as well as the valuation cap.

Apart from simplicity, Simple agreement for future equity (SAFE) is different from convertible notes in the sense that it is not a debt instrument. From the very first day of the investment, a Simple agreement for future equity (SAFE) does not obligate the startup towards making any monthly interest payments. Also, there is no maturity date for Simple agreement for future equity (SAFE) instruments. This is the major difference that makes this financial instrument completely different from convertible notes.

Types of Simple agreement for future equity (SAFE) Instruments

The SAFE instrument can be of various types. The variation in the different types of instruments stems from the way in which these instruments are converted to equity. Some of the common variations have been listed below:

1. Discount SAFE: Discount SAFEs are financial instruments that function like convertible notes. This means that these SAFEs have a discount factor. If the discount factor is 20%, then the holder of the SAFE will be allowed to convert to equity at a 20% discount as compared to other shareholders.

2. No-Cap SAFE: In some cases, investors might not want to use the discount feature of the SAFE. It is common for them to trade the discount feature for a no valuation cap feature. This type of SAFE does not have any valuation caps. Hence, an investor can obtain a very high equity stake in the underlying company if they use the No-Cap SAFE option.

3. MFN SAFE: There are other types of SAFE instruments as well in which the terms and conditions of the SAFE are not decided in advance. However, the startup founders promise to give the “most favored nation” status to SAFE investors. This means that they promise the SAFE investors the best deal compared to other investors. Hence, the startup founders are obligated to give these investors better discount terms and no cap terms as compared to other investors.

Pre Money Vs Post Money SAFE

There is another variation in the type of Simple agreement for future equity (SAFE) which is available in the market. SAFE instruments can be further classified as pre-money SAFE and post-money SAFE. The difference between the two is that in the case of pre-money SAFE, the investors do not know the percentage of the company that they will own once the SAFE is converted into equity. This percentage is dependent upon the priced rounds of investments. On the other hand, when it comes to post-money SAFE, the investors are very sure about the percentage of equity they will hold in a company after the SAFE is converted into equity shares.

Events Governing the SAFE

Even though Simple agreement for future equity (SAFE) is considered to be a very “simple” financial instrument, investors and founders would be better off if they knew exactly what to expect if the following events were to take place.

1. Equity financing: Most SAFE instrument agreements are very clear on what happens if an equity financing round takes place. Hence, much clarity is not required in this case. However, investors must clarify whether they will be provided shares in the company or will be paid the cash value of the shares in the company after an equity financing takes place.

2. Liquidity event: It is possible for a company to be sold to another company before the conversion of SAFE to equity shares. Investors and founders must clarify what will happen to the SAFE instruments in this case.

3. Dissolution: It is also possible for a company to go bankrupt before the conversion of SAFE to equity shares. Both parties would be better off knowing their rights and obligations if this event were to take place.

The bottom line is that SAFE is a different type of financial instrument as compared to convertible notes. SAFE is considered to be more founder-friendly since it does not immediately put them under a debt burden. However, it is not used by many investors for the exact same reason.