What exactly is a SAFE, or Simple Agreement for Future Equity? A SAFE represents a popular method for investing in very early-stage companies. In essence, it’s a contractual agreement where an investor provides funding to a startup today, and both parties agree that this funding can convert into company stock at a later date.
Interestingly, the concept of the SAFE was developed by two individuals from the Y Combinator team back in 2013.
So, when does this conversion to stock actually take place?
This magical transformation occurs when the startup initiates its next official round of fundraising. For most startups on Syndicately, this next round is referred to as “Series A,” as crowdfunding on our platform typically serves as their initial funding phase.
Typically, during this Series A round, the startup sells its stock to venture capitalists (VCs) who are professional investors managing large sums of money from various sources.
Now, you might be wondering if this guarantees a quick return for Syndicately investors. Well, not quite. In reality, a successful startup often goes through multiple rounds of fundraising with VCs, and it can take several years before Syndicately investors see any substantial returns. Investing in startups usually requires a long-term perspective, and using SAFEs is no exception.
But what are the key terms to understand in this agreement?
In most cases, the SAFEs you encounter on Syndicately have a crucial element known as the Valuation Cap. This feature is favorable to investors as it sets a maximum limit on the price per share when the SAFE converts. The lower the cap, the lower the price per share, which means investors can expect to own more shares when the conversion takes place.
Let’s say you invest using a SAFE with a $5 million cap, and during the Series A round, the company is valued at $50 million, with shares priced at $1 each. Your SAFE will convert as if the price were still $5 million, resulting in an effective price of $0.10 per share. Essentially, SAFE investors hope that the startup’s valuation surpasses this cap in the next round, allowing them to convert their investment at a lower price and acquire more shares.
Occasionally, you may come across a SAFE with a Discount Rate, typically ranging from 10% to 20%. This means that investors’ money will convert to shares at a discounted rate, providing early investors with more shares upon conversion than those who invest in later rounds.
Sometimes, a SAFE might have both a discount and a cap, but only one of these terms is applied. If the Series A funding exceeds the cap, the cap takes precedence. If it falls short, the discount comes into play. In this way, the discount acts as a kind of safety net.
Most Favored Nation (MFN)
The final type of SAFE found on Syndicately is an uncapped SAFE with a Most Favored Nation (MFN) clause. In these “uncapped” SAFEs, there is no cap or discount. This type of SAFE is most common among very early-stage startups that prefer flexibility and early investors looking to get involved in the action.
The MFN clause in this type of SAFE provides some security to early investors. It states that if another SAFE investor later negotiates either a cap or a discount, the earlier investor can choose to adopt those terms.
Why do startup founders favor SAFEs?
Early-stage startups appreciate SAFEs for three main reasons:
SAFEs offer a quick and straightforward method compared to selling actual stock, which can involve substantial legal fees and complexities. By issuing SAFEs, founders can raise funds, focus on growing their business, and defer the involvement of contract lawyers until VC funding rounds.
SAFEs eliminate the need for founders to estimate the value of their company, as the Valuation Cap is not meant to determine the actual valuation but rather to reward early investors for taking a risk on a fledgling enterprise.
SAFEs are not loans, which distinguishes them from Convertible Promissory Notes (C-Notes). C-Notes involve accruing interest, a maturity date, and a legal obligation for the startup to repay the investor, though this is rarely exercised in the event of bankruptcy.
Why do investors favor SAFEs?
SAFE investors can secure terms similar to those that VCs spend significant resources negotiating for their preferred stock. VCs typically obtain “preferred” stock with a set of negotiated terms. SAFE investors benefit from these terms at a lower price per share.
Is there a possibility that a SAFE may never convert?
Yes, there is a chance. Sometimes, after crowdfunding on Syndicately, a startup may be acquired by a larger company, referred to as an “early exit” in startup terminology. In such cases, SAFE investors have two options: they can either recoup their initial investment or receive the amount they would have been entitled to if the SAFE had converted based on its terms.
There is also the real possibility that the startup might dissolve or go bankrupt, in which case SAFE investors are unlikely to receive payments.
Lastly, it’s possible that the startup may never proceed to another official round of fundraising. In such cases, Syndicately may recommend different contract types for startups that do not require VC funding to succeed.
Are SAFEs riskier than other contract types?
From a legal perspective, SAFEs are riskier than C-Notes because they do not involve loans. However, in practice, investors who use C-Notes rarely see repayment if the company faces financial difficulties. Beyond this difference, SAFEs and C-Notes are quite similar and are comparable in terms of investor risk.
Compared to directly purchasing preferred stock, SAFEs are riskier because they represent a promise of stock rather than actual stock ownership. Nevertheless, SAFE holders have the potential for higher returns due to the risk they assume.
While SAFEs are riskier than simple loans or revenue-sharing contracts, they are typically suited for different types of startups.
Can Syndicately investors calculate the number of shares they will receive based on their initial investment and the valuation cap?
Unfortunately, investors cannot accurately determine the number of shares their SAFE will convert into until the actual conversion event occurs, usually during an official or “priced” funding round. Various factors, such as the number of shares already in circulation and the size of the employee option pool, influence this calculation.