Simple Agreement for Future Equity (SAFE)

What is a Simple Agreement for Future Equity (SAFE)?

A SAFE is a convertible instrument commonly used as a form of consideration in a pre-seed, seed or seed+ round of capital. It is essentially a contract between an early-stage company and an investor who agrees to provide a specified amount of equity at a certain point or specified event in the future, following investment in the company. A SAFE allows a company to raise capital in return for the right to issue equity later, usually when a liquidity event such as a fundraising round or sale occurs.

Most seed rounds are unpriced rounds, which are easier to negotiate than a priced round because there is no valuation to agree on and the documentation is simpler with fewer terms. Convertible instruments are typically used as consideration in unpriced rounds, with the two most common being traditional convertible notes and SAFEs.

SAFEs are neither equity nor debt instruments, they do not have a maturity date, and do not carry an obligation to pay interest. However, they are legally binding agreements that represent a contractual right for investors to receive shares at some point in the future, usually the next financing round. For seed investors, this is typically the Series A round.

Priced vs. Unpriced Rounds of Capital

For many start-up companies, the seed rounds are their first round of capital investment, and these can be either priced or unpriced. A priced round indicates that the startup has a valuation and that shares purchased for cash by investors are sold at a price derived from the agreed valuation. In contrast, an unpriced round has no determined valuation and therefore there is no purchase price for company stock. Instead, investors sign an agreement to provide cash to the startup in return for shares in a future priced round.

What is the Difference Between a Simple Agreement for Future Equity SAFE and a Convertible Note?

Convertible Notes are traditional financial instruments issued first as debt and can then be converted to equity under the specific terms of the note agreement. Until they are converted, they are like a debt instrument with a specific interest payment and a maturity date.

For some investors, these traditional debt-like features provide some reward for the risk that investors are taking by investing so early in a startup. Included in the agreement are terms related to the specific events that would trigger the conversion of debt to equity. These would be negotiated between the investor and the startup when the investment was made.

SAFEs are simpler and can be more flexible. They were introduced in Silicon Valley in late 2013 by Y Combinator (a start-up investment accelerator and tech incubator) based on their desire create a simpler agreement with fewer terms to negotiate and that was less onerous for entrepreneurs. In short, they wanted a more founder-friendly solution than convertible notes that still offered an attractive return for early-stage investors.

Most Favored Nation (MFN) Clauses in SAFEs

The most favored nation (MFN) clause allows early investors to request and receive identical provisions or rights included in later rounds, particularly if they’re considered favorable. This is generally a term included in SAFEs but not convertible notes, because they lend themselves more to a fundraising process on a rolling basis, whereby investor capital does not come in at the same time.

MFN Example

For example, consider three investors who invest in an early-stage company at different times, each receiving different terms. Investor A may have a discount rate, Investor B may have a valuation cap, and Investor C has both. Investor C has the best deal as they can choose the better of the discount or the valuation cap. However, if Investors A and B also have a most favored nation clause in their SAFE, they would receive the same terms as Investor C. They would also be able to choose the better of the two options, even though they didn’t receive that right when they invested themselves. This allows them to choose between the discount rate and the valuation cap, whichever is better, as was offered to Investor C. SAFEs aren’t locked into a fixed valuation or timeframe, so they can be used on what’s known as a rolling basis. They are no longer used once the company is valued.

Advantages and disadvantages of SAFEs

Advantages of a SAFE

• Flexible financing option for founders allowing them to focus on company growth.
• Unlike debt instruments, they do not accrue interest and do not need to be repaid.
• Since there is usually no fixed maturity date, SAFEs can sit on a company’s books conceivably forever without any mechanism requiring the company to act.
• Investors are compensated with discount rates and valuation caps on the future conversion of their cash investment into equity.

Disadvantages of a SAFE

• Unless there is a future priced round or sale of the company, SAFE investors may never convert their investment to equity and may never see a return on their investment.
• Alternatively, if the startup performs extraordinarily well and never needs a priced round financing that triggers conversion to equity, then a SAFE investor may never receive equity in the most successful start-ups.

How Does a Simple Agreement for Future Equity Work?

Two terms included in BOTH convertible notes and SAFEs and that must be negotiated in an unpriced round are discount rates and valuation caps.

Discount Rates

Discount rates are the percentage discount to the price of shares that a seed stage investor can purchase in the next priced round. A typical discount rate is 20% but can range anywhere from 5-30%. Investors will negotiate for a higher discount to the price per share of the priced round to yield more shares to compensate for the higher risk, earlier investment.

Valuation Caps

Valuation caps are a ceiling on the company’s valuation to determine the price per share at which an investor’s initial investment in the startup converts to equity. This cap remains in place even if the other investors in the priced round agree to and pay a different price per share based on a higher valuation. The investor benefits from this as it ensures that investors get a certain percentage share of the company in the conversion and can prevent an excessive valuation from squeezing the percentage share that an investor can purchase in the startup.

Both terms act as incentives to investors to assume the higher risk that comes with investing so early. If the convertible note or the SAFE has both a discount rate and a valuation cap, the Investor typically exercises the option that gives them the lowest conversion price per share.

Download the SAFE Agreement template from Y combinator that has been annotated to highlight the key features.

SAFE Example

The example below illustrates how a conversion is calculated on a $50,000 investment with a SAFE agreement offering a 20% discount rate and a $4m valuation cap. The SAFE investor would receive 6,250 shares under the 20% discount rate term in their agreement, or 15,000 shares if they had a valuation cap of $4 million. If an Investor had both features included in their SAFE agreement, the investor would likely choose the valuation cap and receive 15,000 shares.

Conclusion

SAFEs are convertible instruments that provide investors in unpriced early-stage investment rounds (typically seed rounds) with the contractual right to the future conversion of their cash investment into equity. Unlike convertible notes, they are not debt, have no maturity date, and pay no interest. They are a simpler and less onerous agreement for the founders of a startup to negotiate with Investors. As an incentive to Investors, they typically offer a discount rate on the purchase price of shares on the next priced round or a valuation cap on the next priced round or both.

If you’re looking to start a career in venture capital, enroll in the venture capital course to master the practical skills needed to succeed as an associate at a VC fund. Learn the core concepts of venture capital, start-up valuation methods, as well forecast models used in the industry. Browse through our online finance courses and upskill today.