Valuing a fledgling startup with no track record is often difficult. This prevents many early-stage startups from acquiring funding from investors. That’s where a SAFE, or a simple agreement for future equity, comes in.
The concept of a SAFE agreement was coined in 2013 by startup accelerator Y Combinator – which counts among its alums the likes of AirBnB, DoorDash, Dropbox, Instacart and Reddit – and it essentially solves the problem of needing to fundraise before there is enough information to value a company.
Let’s take a look at the benefits of using a simple agreement for future equity for early-stage startups.
What is a simple agreement for future equity
A SAFE agreement is an option for obtaining early-stage startup funding. A simple agreement for future equity delays valuation of a company until it has more performance data on which to base a valuation. At the same time, it promises an investor the right to buy future equity when a valuation is made. A SAFE can be converted into preferred stock in the future. SAFE investors do not hold stock immediately. Rather, it may take four to six years for the investment to convert to equity – if at all.
How does a simple agreement for future equity work?
Let’s look at the example of an investor who invests $50,000 in a startup through a SAFE. In this scenario, the startup receives additional funding from an angel investor within two years. At that point, the startup is valued at $20 million. If shares in the company are priced at $1 each, then the original SAFE investor would get 50,000 shares.
However, SAFEs often have additional terms and conditions. A simple agreement for future equity term sheet lays out the relationship between the startup company and the investor and determines how the SAFE works. The terms of SAFE contracts establish “triggering liquidity events” or points at which an investment would convert to equity, like future financing or acquisition. Both parties can also agree to a conversion.
A SAFE agreement may also include:
- Valuation cap. A valuation cap sets the maximum valuation at which SAFE investments convert into equity, even if the actual valuation is higher. So, a SAFE investor receives a greater return the higher the valuation at the time of sale.
- Discount. A discount may be used if the SAFE investment converts into SAFE equity when the valuation is at or below the valuation cap. This allows investors to buy shares at a discounted valuation.
- Pro-rata rights. These rights permit investors to increase their investments to maintain equity percentages after financing rounds.
- Most-favored nations provision. An MFN is a non-discrimination clause that requires startups to confer the same privileges to all investors. So, if better terms are offered to future investors, previous investors will also receive these beneficial terms.
SAFE Pros and Cons
Check out the advantages and disadvantages of SAFE agreements to determine if this type of investment instrument would work well for you and your startup.
- A future equity agreement is not debt. SAFE agreements do not accrue interest, and with these types of agreements, you will not have debt on your balance sheet. Also, startups are not required to repay SAFE investors if they fail, and there is no time pressure for converting SAFE notes into equity.
- SAFE agreements are typically standardized. Between investments, simple agreements for future equity don’t vary much, and are fairly standard. They are also easy to issue, which benefits companies eager to get up and running swiftly.
- SAFEs offer special benefits to investors. When they do work out, SAFE investors have more advantageous rights than common stockholders.
- SAFE agreements are high risk. These investments don’t convert to equity unless a liquidity event occurs.
- The standardization of SAFE agreements inhibits flexibility. This type of investment instrument lends less flexibility than others. The structure of SAFE notes doesn’t vary much between investments, a convertible note, which is a short-term debt that converts into equity. To learn more about the difference between these investments, Founders Network has additional resources for determining which is more suitable for you and your company. Check out our blog on the benefits of using a convertible note vs. equity.
- SAFE contracts can be hard to get out of. Typically, you can sell a simple agreement for future equity only after a year has elapsed since the purchase date – and that’s if you can find a buyer.