SAFEs: Are they really that simple?

SAFEs:

Are they really that simple?

If you’ve been working in venture capital over the past 5-10 years, or if you’ve been raising capital for technology startups over this period, chances are you’re pretty familiar with simple agreements for future equity (aka SAFEs). For anyone else, it could well be that you have no idea what we’re talking about.

No worries; this article explains what SAFEs are and how they work – with some basic examples – as well as their benefits.

1. What is a SAFE?

SAFE stands for simple agreement for future equity. A SAFE is usually a relatively simple agreement by which funds invested into a company will convert into shares in that company upon certain trigger events.

SAFEs are usually much shorter than a subscription agreement (under which shares are issued to investors at the same time that they hand over their cash) in conjunction with a shareholders’ agreement (governing the relationship between the company and its shareholders).

At this point, it’s important to emphasise that a SAFE is a contract. Parties to contracts are free to agree departures from the general rules set out in this article and still call their arrangement a SAFE. Not all SAFEs are the same so make sure you and your advisers read them from cover to cover.

2. When do they convert?

SAFEs usually convert into shares upon a qualifying financing or, at the investor’s election, just before an exit event, whichever occurs first.

Qualifying financing

A qualifying financing means a bona fide equity fundraising event (or series of related events) for the principal purpose of raising capital through the issue of shares and by which the company raises a minimum amount of money. That minimum amount of money need not but often happens to be a multiple of the amount invested per the SAFE.

Exit event

An exit event means the sale of all (or substantially all) of the company’s shares or assets in a bona fide single transaction (or series of transactions) or an IPO of shares in the company (or its holding company) on a recognised stock exchange.

So, put another way, SAFEs will convert when future investors or buyers place a materially bigger bet on the success of the relevant business.

3. What shares do you get at conversion?

In the case of a qualifying financing, the SAFE may convert into ordinary shares but will often convert into shares of a class issued as part of the qualifying financing and having the most favourable terms.

In the case of an exit event, the SAFE will not always convert, rather the investor will often be able to elect to have their investment returned or have their SAFE convert into shares of a class then on issue and having the most favourable terms. If they elect for conversion, this will take effect shortly before the exit event so that they can participate in such.

4. What actually converts?

Usually just the amount invested but sometimes it’s that amount plus interest at a pre-agreed rate that has accrued on that amount.

5. What is the conversion rate?

The amount invested often converts into shares at the lowest price per share paid by those subscribing for new shares as part of a qualifying financing or the lowest price per share (or effective price per share) paid by those purchasing share capital or assets as part of an exit event, as applicable, subject to adjustments described below.

Discount rates

The company and the investor may agree that conversion is to occur at a discount to what would otherwise be the conversion rate. Such a discount is often in the range of 15-30%.

For example, if the unadjusted price per share (or effective price per share in the case of an exit event by way of asset sale) is $1 and the discount is 20% then the investor should receive 25% more shares as a result of the discount.

Valuation caps

The company and the investor may also agree on a (company) valuation cap that effectively caps the conversion rate. These valuation caps will vary from company to company and will reflect the tension between the company’s growth prospects and the minimum percentage of the company sought by the investor.  

For example, if the company is raising $2m at a pre-money valuation of $8m and this constitutes a qualifying financing, then a $1m SAFE with a $5m post-money valuation cap will convert into shares equal to 20% of the company, which is the same amount that will be issued to those subscribing for new shares as part of a qualifying financing, and which is equivalent to a 50% discount. If in the scenario described above the investor instead holds a $1m SAFE with a $5m pre-money valuation cap, that SAFE will convert into shares equal to 16.67% of the company, which is equivalent to a 40% discount.

Note that in the case of each of the examples above, we assume that there are no other SAFEs or other instruments capable of converting into shares in existence let alone converting into shares, and that there are no other adjustments.

Most favoured nation

In exceptional circumstances, the company may confer on the investor what is often referred to as most favoured nation status such that the investor enjoys any more favourable discount rate and any more favourable valuation cap that attach to any other SAFEs.

6. Do you need to do anything else to get your shares?

Yes, investors will usually be required to have entered into a shareholders’ agreement or acceded to such before they can be issued their shares.

7. Do SAFEs ever need to be repaid?

Generally not, however, there are two notable exceptions.

In the case of an exit event, the investor may elect to have their investment returned instead of having their investment convert into shares.

A dissolution event means a liquidation or winding-up of the company. In the case of a dissolution event, the SAFE investor will be entitled to receive a portion of amounts available for distribution to shareholders equal to the SAFE investment.

8. What happens if the company goes broke?

SAFEs generally carry what is called a liquidation preference. In practice, this means that in an insolvency scenario the investor will have their investment returned before any distribution is made to shareholders but will not see a cent until all creditors (including the holders of convertible notes) have been paid in full. If the company has issued more than one SAFE, the holders of SAFEs will be paid at the same time pro rata according to the size of their investments.

9. Can other special rights attach to SAFEs?

It’s not uncommon for investors to have a right to receive annual financial statements and in some instances they may also be able to insist on access to quarterly management accounts.

Beyond that, investors may also negotiate the right to participate in a qualifying financing as if their SAFE had already converted into shares.

10. How is a SAFE different to a convertible note?

Unlike SAFEs, convertible notes have a term at the end of which the company will be obliged to repay, or the investor will have the right to require repayment.

11. What are the main advantages of SAFEs versus subscribing for shares?

If indeed SAFEs convert into shares only when future investors or buyers place a materially bigger bet on the success of the relevant business, and it is reasonable to assume that such future investors, in addition to having greater time to assess the company, will deploy considerably greater resources to undertake due diligence, settle on company valuation and resolve a sufficiently investor-friendly form of shareholders’ agreement, then it is far less critical that a prospective SAFE investor do these things today.

This – especially in conjunction with a discount rate and/or valuation cap – can give investors comfort that they will not be overpaying for their shares when they eventually get them, which in turn – and together with a liquidation preference – can spur them to invest earlier or where they otherwise wouldn’t.

Conversely, SAFEs can give the company comfort that they are not giving away too much of the company and they allow the company to raise funds more quickly while containing theor own associated transaction costs.

12. Are there any drawbacks?

Before their SAFEs convert, investors will not (unless they are already shareholders) enjoy customary shareholder rights, including rights to vote, receive a portion of dividends declared and paid and participate in new share issues, but these shortcomings are usually far outweighed by the benefits when younger and/or riskier companies with little runway need cash.  

This, in a nutshell, explains the popularity of SAFEs today as a capital raising instrument.

Contact us

If you’re wondering whether a SAFE is the right way for your team to raise capital, or if you want a SAFE prepared or reviewed, reach out to our team.