Start-ups and emerging companies are always seeking future investment opportunities. In recent years, a financing alternative called Simple Agreements for Future Equity (“SAFEs”) has gained popularity and proven useful for emerging companies when conducting their early-stage raises. SAFEs offer an efficient mechanism for raising capital in the early stages of an emerging company.
SAFEs emerged due to the need to bridge the financing gap during early-stage investments where the value of the company was unknown or difficult to determine. SAFEs enable companies to raise capital by granting investors the right to receive equity in the future, upon the occurrence of specific triggering events. This article explores the key provisions and advantages of utilizing SAFEs in comparison to other financing instruments. Additionally, this article will outline some of the key issues emerging companies should be aware of when structuring SAFEs and how to best avoid pitfalls that may arise when utilizing this financing option.
What Are SAFEs?
SAFEs are company-friendly investment contracts between the company and each investor that give the investor the right to receive equity of the company in the future upon the occurrence of certain triggering events. The main purpose of a SAFE is to enable an early-stage investment in a company to bridge finances until the occurrence of a larger financing round. Upon such future financing round, the advance investment will convert into shares, with the investor benefiting either from a discount in purchase price or a capped value.
SAFEs have gained popularity in recent years due to their distinct advantages over convertible notes, a topic that will be covered in a future article. Convertible notes often create conflicts with existing debt obligations and involve complex negotiations among different investors and institutions. Conversely, SAFE agreements offer a streamlined model that eliminates the need for intricate discussions surrounding interest rates and specific terms. This simplified process benefits both companies and SAFE holders, making SAFEs an attractive financing option.
Structuring the SAFE
It is important to note that SAFEs come in different variations, such as post-money SAFEs and pre-money SAFEs. Post-money SAFEs provide investors with a predetermined ownership percentage in the company after the occurrence of a future financing round. On the other hand, pre-money SAFEs do not account for the valuation of the future financing when determining the ownership percentage. Companies should carefully consider which type of SAFE best aligns with their financing goals and the expectations of their potential investors, as post-money SAFEs may lead to unintended anti-dilution protection on a full-ratchet basis in the event of a down round.
In order to understand the benefits of and potential drawbacks to utilizing SAFEs, companies should be aware of the key provisions in a SAFE agreement, namely provisions relating to triggering events, valuation caps, discount rates, and most favored nations clauses.
One of the main characteristics of a SAFE is that equity rights are granted whereby if the company undergoes a triggering event (which is defined in each SAFE agreement), the SAFE will convert into securities of the company. Triggering events tend to be subsequent financings of the company or liquidity events, such as the company commencing the bankruptcy or dissolution process. When a triggering event occurs, the holder has the benefit of the SAFE converting to equity at the negotiated discount in the SAFE, which allows the holder to obtain rights as a shareholder. Upon a dissolution, SAFE holders who have not converted their SAFE into securities would be paid the purchase amount they were guaranteed by the company before common shareholders are paid.
This is a discount to the price per share outlined in the SAFE agreement that will be issued by the company to SAFE holders upon a triggering event. It is an incentive for investors to enter into a SAFE agreement, because purchasing the SAFE at earlier stages locks investors in to convert their SAFEs at a lower price upon a triggering event.
As an example, a company may incentivize early-stage investors through offering a SAFE that will convert at a price per share of $1.00. Upon the occurrence of a future financing at $1.20/share, the SAFE holder will receive the upside because the financing (which would constitute a triggering event) allows the SAFE holder to convert their SAFE into shares at $1.00/share.
Valuation caps are often used to establish the upper limit on the valuation of the company at which a SAFE will convert into shares. This has the effect of creating a floor for the percentage of the company the investor is purchasing. The valuation cap ensures that the SAFE holder receives a lower price per share than subsequent investors.
Most Favored Nations Clause
Most favored nations clauses may be used to provide a SAFE holder with certainty that, upon a future financing, if the terms of the future financing are more favorable to the investors than the SAFE is to the SAFE holder, the SAFE holder will receive the benefit of receiving the best terms for themselves. This serves as another incentive for investors to acquire SAFEs, because they won’t face the repercussions of investing too early if subsequent financings contain better terms.
To ensure investor protection, SAFEs can incorporate provisions that grant transparency and information rights to SAFE holders. Regular updates on the company’s financials, milestones, and progress can be provided to investors, enabling them to make informed decisions about their investment. By fostering a relationship of trust and transparency, companies can attract and retain investors who feel confident in the growth trajectory of the company.
Companies and investors should be mindful of the potential tax implications associated with SAFEs. The tax treatment of SAFEs can vary depending on the jurisdiction and individual circumstances. It is advisable to consult with tax professionals who can provide guidance on the specific tax implications of SAFEs, including any applicable capital gains taxes, reporting obligations, and potential tax advantages or disadvantages. By understanding the tax implications, companies and investors can effectively plan and strategize their financial decisions, ensuring compliance and optimizing their tax positions.
SAFE holders should consider the potential exit strategies available to them. While SAFEs provide the opportunity to convert into equity upon triggering events, investors may also seek liquidity through other avenues. Acquisition by another company, initial public offerings (IPOs), or secondary market sales are possible exit strategies for investors. Companies can proactively communicate their long-term plans and potential exit scenarios to investors, allowing them to evaluate the feasibility of realizing their investments and potential returns. By understanding the available exit strategies, investors can make informed decisions about their participation in early-stage companies.
Limitations and Considerations
It is important to acknowledge that SAFEs may not be suitable for all companies or industries. While SAFEs offer advantages, institutional investors or certain industries may prefer more traditional financing instruments, such as convertible notes or preferred stock. Companies should carefully assess their financing goals, investor preferences, and industry norms before deciding to adopt SAFEs. Additionally, legal and regulatory considerations, including compliance with securities laws and the enforceability of SAFEs, should be evaluated. Consulting legal professionals can help companies navigate the legal landscape and ensure that SAFEs are structured and implemented in a legally compliant manner.
For start-ups and emerging companies, SAFEs provide a compelling capital raising alternative, particularly in the early stages or when the company’s valuation is not yet established. SAFEs offer a simplified process, company-friendly provisions, and lower costs compared to other financing instruments. Investors are incentivized to participate early through discounted rates upon conversion of the SAFE into securities and potential preferential treatment during insolvency scenarios. By leveraging SAFEs, companies can access streamlined capital and fuel their growth without hindering immediate progress.
The creation and implementation of SAFEs should involve consultation with legal professionals. Legal counsel can provide guidance on complying with applicable securities laws, assessing the enforceability of SAFEs in different jurisdictions, and addressing any jurisdiction-specific regulations. By seeking legal advice, companies can mitigate potential legal risks, ensure compliance, and protect the rights of both the company and the investors. Legal professionals can also assist in drafting and negotiating the terms of SAFEs to accurately reflect the intentions and expectations of the parties involved, further enhancing the legal robustness of the agreements.