What is a SAFE Investment?
In 2013, startup accelerator, Y Combinator, introduced a new way for investors to invest in startup companies. The Simple Agreement for Future Equity, or SAFE, was created as a simpler alternative to convertible debt and equity investments. Under a SAFE, the investors invest money in the company using a SAFE, in exchange for which, the investor receives the right to receive stock in a future equity round, when one occurs, subject to certain parameters set in advance in the SAFE. In practice, a SAFE enables a startup company and an investor to accomplish the same general goal as a convertible note, even though a SAFE is not a debt instrument.
LISTEN: Recently, Neil Bagchi recorded a Tweener Fund podcast with Scot Wingo as they discussed a “Deep Dive into SAFEs”. Don’t miss their webinar including the recap, replay & supportive materials.
Main items to consider when issuing SAFEs
- Investment amount
- Mechanism for conversion
- Dilutive effect on the shareholders of the company upon conversion
In most cases, amounts invested through SAFEs convert into equity using a conversion mechanism that rewards the SAFE investors by offering such investors a conversion price that should be lower than the actual purchase price of such equity by new investors. For this reason, it is important to carefully model out the potential future dilutive impact of the SAFE investments. As the SAFEs do not translate to equity immediately being issued, companies can be tempted to raise more money than they actually require through SAFEs. Once the SAFEs convert, however, founders may be subject to a greater amount of dilution than originally anticipated.
The prices at which SAFEs convert into equity typically are based on a valuation cap or a discount rate. The standard SAFEs contain either the valuation cap or the discount rate; however, both the valuation cap and the discount rate may be deployed in the same SAFE instrument.
The valuation cap essentially sets the company valuation that will be used to determine the SAFE’s conversion price, which, in turn, is used to calculate the amount of equity to be issued upon the conversion of the SAFE. If, in an equity financing (subsequent to a SAFE financing), the company is valued at a valuation higher than the SAFE’s valuation cap or if the SAFE’s valuation cap is set too low, the SAFE conversion can result in a disproportionately large percentage of equity being granted to the SAFE holder upon conversion. The discount rate provides a SAFE holder with the right to purchase equity at a discounted rate as compared with the price per share of the equity being issued in connection with an equity financing.
Of the two conversion mechanisms, the discount rate is the company-favorable mechanism. Investors prefer valuation caps as they could result in a large percentage of equity being granted, whereas companies prefer discount rates as it has a measure of control by proportionally increasing the amount the SAFE holders will eventually pay for their shares. It is important to understand these conversion mechanisms when negotiating the terms of the SAFE.
Comparing term options of the SAFE and its impact on dilution
Discount Rate – The rate at which the SAFE conversion price is discounted as compared to the price the equity financing round investors will pay. Discount rates are typically between 10-25%.
- Effect on dilution – SAFE holders will pay a lower price per share upon conversion, thus receiving a higher total percentage of the company’s equity.
Valuation Cap – The valuation cap sets a maximum company value for purposes of determining the SAFE conversion price.
- Effect on Dilution – The valuation cap provides the SAFE holder a lower price per unit of equity to purchase shares upon conversion, thus receiving a higher total percentage of the company’s equity.
Both Discount Rate and Valuation Cap – Allows the SAFE holder to receive the greatest amount of equity into which the SAFE converts by selecting between the two mechanisms.
- Effect on Dilution – Provides SAFE holders with the right to receive the largest amount of equity by using whichever mechanism is most beneficial to the SAFE holder. This optionality leads to greater dilution for the company’s common equity holders.
Most Favored Nation clause (MFN) – If convertible securities are sold to investors at a later date on more favorable terms, the SAFE holders can opt to receive the same terms.
- Effect on Dilution – Allows SAFE holders to receive a larger percentage of the company’s equity if terms granted to future investors would allow for it, even though the SAFE holders did not negotiate for or receive such terms.
Pro-rata rights – Pro-rata rights entitle the SAFE holder to subscribe for a percentage of the total priced equity financing round equivalent to their as-converted ownership.
- Effect on Dilution – SAFEs generally convert immediately prior to a priced equity financing round, meaning the incoming preferred equity will dilute the ownership of a SAFE holder. Pro-rata rights allow a SAFE holder to offset such dilution and retain the same amount of ownership. As such, more equity will be issued and the existing owners of the company will be diluted further.
To recap, a SAFE is a tool that can be used by startups and investors to reach the same goal as convertible securities, without incurring debt. Negotiating a SAFE investment requires careful consideration of investment amounts, mechanisms for conversion, and dilutive effect. When used correctly, SAFEs can be very beneficial and practical for all parties involved.
Many founders underestimate the level of dilution that can occur upon conversion and are surprised when they see their ownership percentage decrease significantly. It is important to remember that a SAFE is an investment and should be treated as such. Pay special attention to the expected dilution upon conversion when negotiating the terms of a SAFE financing round. Be sure to do your research and consult with a qualified advisor before issuing or investing in a SAFE. If you are considering a SAFE financing round and would like any assistance or have any questions please contact Bagchi Law.
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