In the world of early-stage startups, founders face a significant challenge: getting the funding they need. To attract investors without giving away too much ownership or control, startups often turn to ‘SAFE’ agreements. In this article, we’ll explore how these agreements can be a game-changer for startups seeking financial support.
What is a SAFE agreement?
SAFE, which stands for Simple Agreement for Future Equity, was introduced by startup accelerator Y Combinator in late 2013. It’s a contractual agreement between a startup company and its investors, giving the latter the right to preferred shares in the startup when the company raises a future round of funding.
SAFE’s main purpose is to help early stage startups raise funds with the help of seed stage investors without exchanging equity or going into debt. It sets out conditions and parameters for when and how the funding can be converted into equity. It’s straightforward, cost-efficient, and easy to implement, which is why the startup community has embraced the use of the agreement in their businesses.
Benefits of the SAFE agreement
Easy to understand
If you plan to adopt the agreements published on Y Combinator’s website, you’ll find the document is simple and straightforward, with fewer variables to understand and negotiate. This saves time and allows the deal to move faster and more efficiently. It also allows you to save associated costs in relation to your agreement.
No interest payment and maturity date
A SAFE agreement removes features in convertible notes, like interest payments and maturity dates, which often cause trouble for startup founders, especially those who lack an accounting and financial background. The agreement ensures startups won’t have to worry about keeping track of interest expenses or asking investors for extensions when maturity dates approach, allowing owners to focus on growth.
No repayment of the investment amount
SAFE agreements are advantageous to startups because they do not impose any obligation on the founder to repay the investment if the SAFE never converts into a security. While it might seem unfavourable to investors, most professional seed-stage investors already know the risk of investing in early-stage startups.
Startups can close with investors quickly.
One round of funding typically requires a lot of coordination to align all investors, including signing documents and providing money on a single close date. Startups that use a SAFE agreement can quickly close with an investor once both parties are ready to sign and the investor is able to wire money to the company. This is called high-resolution fundraising.
Disadvantages of the SAFE agreement
While a SAFE agreement seems simple and beneficial to startups, it also comes with its own set of risks.
No equity stakes
SAFE investors are not equivalent to being a shareholder. SAFEs are not equity stakes in the startup company, so investors will not be protected under the Corporations Act or any other ancillary protective measures offered to shareholders. They are entitled to future equity only if certain conditions are triggered. If those conditions never occur, they might not get their investment back.
Too simple
As startup companies can easily raise money with SAFE agreements, founders often raise money without knowing its impact on the capitalisation table. When the SAFEs eventually convert, founders realise too late how much of their company they’ve given away and how much it has diluted the business.
What to keep in mind before entering into a SAFE agreement:
If you plan to use a SAFE agreement for high-resolution fundraising, here are some crucial points to remember.
Company shares will have the same preferences between SAFE investors and new investors.
When SAFEs convert into equity at the next round of funding, the company sells preferred stock at a fixed valuation. This is different from qualified financing with convertible notes, as there is no minimum size of the round.
During equity financing, the investment from the SAFE investor converts into shares of preferred stock in the company. These shares will have the same preferences, rights, and restrictions as the preferred shares of new investors. When negotiating terms under equity financing, startup founders should keep in mind that they are negotiating for both new investor and SAFE investor shares. The number of preferred shares the SAFE agreement converts depends on whether or not there is a discount or cap.
Startups will benefit more from uncapped and discounted SAFE
A SAFE discount is used to mitigate the higher investment risk that SAFE investors take when investing in an early-stage startup. It is a discount off the price per share that new investors pay in equity financing and ranges anywhere between 5% to 30%, with 20% being the average discount.
This discount is not always enough to protect SAFE investors and their investments, which is why some will opt to use a valuation cap to protect their interests, especially when the company grows a lot faster than expected. A valuation cap is the highest valuation at which the amount invested in the SAFE would be converted into shares. It is the maximum valuation that the SAFE investor will pay, regardless of the actual valuation during equity financing.
An uncapped and discounted SAFE is the ideal scenario for startups. It rewards the investor for taking an early risk while avoiding the challenge of assigning an arbitrary value to the company, which can be too high or low. However, not all early-stage investors would be willing to follow this setup, making it crucial for founders to negotiate the SAFE agreement well.
Ensure smooth SAFE agreements with Lazarus Legal
While there are ready templates for the SAFE agreement, it is mostly intended for use by US companies. It is a must to consult with licensed lawyers if startups wish to adapt the agreement for use in Australia.
Lazarus Legal can assist with all your legal requirements, including providing guidance in amending terms and creating your own variation of the SAFE agreement. We’ll take care of the process so you can focus on raising funds and setting your startup for success. Contact us today or sign up for our newsletter to stay informed about legal news, business trends, and more.
