As a new business owner, you may face the following scenario: You have a great idea and want to get a product or service to market, but you need capital. It can be particularly challenging to find seed investors when your company has not had an official valuation during the early stages of your business. Prior to the Series A financing round, many startup businesses will elect to raise funds through convertible notes or simple agreements for future equity (also called SAFE agreements). Both are fairly easy financing options to put together and do not require the company to have calculated a valuation, however, the SAFE agreement was developed to even further simplify the funding process.
What is a simple agreement for future equity (SAFE)?
A simple agreement for future equity, or a SAFE agreement, is a capital-raising instrument between a company and early-stage investors. To put it simply, it’s an investment contract that states that an investor will provide seed funds in return for future equity that they will receive when a triggering event occurs.
SAFE agreements are similar to convertible notes, which are loans that convert into equity at a later funding stage, but SAFE agreements are considered to be more favourable to the business founder. Convertible notes accrue interest and take time to create, so a startup accelerator called Y Combinator created SAFE agreements to simplify capital access by allowing startup founders to acquire funds during their pivotal early days.
Since it was developed as a way to accelerate funding from convertible note agreements, a SAFE agreement is also considered a type of convertible financing instrument. This means that an investor will agree to a cash investment that will later convert into company shares. The difference is that a SAFE agreement is not debt;it does not have a due date, nor will it accumulate interest.
A SAFE agreement allows the growing company to raise money prior to the business receiving a valuation and distributing shares. The valuation of the company is often the triggering event at which time the investor’s SAFE converts to equity. However, there is no guarantee that the triggering event will occur. If it never does, an investor may not see their investment convert into equity.
How does a SAFE agreement work?
The SAFE agreement promises an investor favourable terms in the future for their early investment. Typically, a SAFE is converted to shares when a triggering event happens. That triggering event is typically the next round of raising capital.
To understand how a SAFE agreement works, it’s important to understand the key terms that can be negotiated within the agreement.
What is a valuation cap?
The most highly negotiated term in a SAFE agreement is the business valuation cap. A valuation cap is the maximum appraised value used to calculate the investor’s SAFE agreement (or a convertible note) into equity. If, at the next round of financing, the company’s valuation exceeds the valuation cap, the investor will receive shares at the lower amount.
For example, Investor X agrees to a $1 million SAFE investment in your company. Investor X sets the valuation cap in the agreement at $5 million.
At the next round of financing, the company has seen some good growth and Investor Y agrees to also invest $1 million but the business now has an official valuation of $10 million.
Investor X will receive their shares of equity pursuant to the initial terms. Investor X will own 20% of the company’s shares while Investor Y will own 10% of the company’s shares. This is a favourable scenario for Investor X, who will benefit from their early investment in the company by setting a valuation cap.
What is a discount?
The next term to know when negotiating a SAFE agreement is discount. A discount is a specific price advantage given to early-stage investors. Rather than setting a valuation cap for the company, the investor’s SAFE agreement will convert into equity at the predetermined discounted rate. The discount is written into the SAFE agreement as a percentage of the total share price. This means that a discount rate of 25% less than the share price would be written as 75%.
For example, Investor X agrees to a $1 million SAFE agreement investment in your company at an 80% discount with no valuation cap.
At the next round of financing, Investor Y also agrees to an investment of $1 million with the company valuation now at $10 million.
Investor X will receive their equity at the discounted rate of 80%. Investor X will own 12% of the company shares while Investor Y will own 10% of the company shares. Once again, Investor X will benefit from their early investment.
Types of SAFE agreements
The above scenarios involving Investor X were more straightforward and simple in order to better showcase valuation caps and discounts. But in reality, their applications are a lot more complex and often combined with each other. Types of SAFE agreement combinations can include:
- Valuation cap with no discount
- Discount with no valuation cap
- Valuation cap and discount
- No valuation cap and no discount
- Most-favoured nation clause: Aa clause that ensures that if later SAFE investors receive more favourable terms, the investor can import those terms into their own agreement
- Pro rata rights: Aa clause that allows investors to keep their share of the company ownership by investing additional funds in future rounds
Finally, it’s important you learn and understand what type of SAFE agreement you will choose: pre-money or post-money.
Pre-money SAFE agreement
A pre-money SAFE agreement is the initial version that Y Combinator developed. In a pre-money SAFE, the investor must wait until the next round of financing (typically the Series A) when the company is officially valued to determine the number of shares the investor is granted and what their stake in the company is. This means that it isn’t easy for investors to know their ownership percentage of the business until after the SAFE converts. Their investment could be at risk of being diluted by other SAFE or convertible note investors.
Post-money SAFE agreement
Four years after developing the pre-money SAFE agreement, Y Combinator introduced a variation called a post-money safe. It benefits both founders and investors because it allows them to immediately calculate the amount of company ownership that’s been sold. The investor is promised a set stake in the company, regardless of what other SAFE or convertible note investments are made. Their investment is not at risk of being diluted by other SAFE or convertible note investors; only the founder’s own ownership is at risk of being diluted. At the same time, the founder will also have more clarity into the amount their business ownership is diluted with each SAFE or convertible note investment.
What is the purpose of a SAFE agreement?
For a business in its early stages, there are many ways to raise funds including grants, crowdfunding, angel investors, venture capital or any other methods. A SAFE agreement is one way that early-stage companies (often startups) raise funds that can be beneficial for both the investor and the business founder.
The benefits of a SAFE agreement are that they generally only involve a simple document (usually around five pages) that requires very little modification. This will save time and lawyer fees in order to allow the growing business to focus on that — growing. Y Combinator describes it as “a flexible, one-document security without numerous terms to negotiate.” The simplified deal terms mean fewer negotiations (mainly just the valuation cap and discount), so the deal moves faster. That means the business founder can be wired the investment funds faster.
SAFE agreements also allow for high-resolution funding. This means the business founder can close with their SAFE investor as soon as both parties sign. There is no waiting period to close simultaneously with all their investors.
How to create a SAFE agreement
A SAFE agreement is very easy to create by design. That is the benefit of using one — it should not require intense negotiations and legal revisions. SAFE agreements were created to be simple enough that they do not require the help of an attorney. Instead, as long as the business founder has a thorough understanding of the various terms, they should be able to create the agreement on their own.
It’s easiest to create a SAFE agreement using a template. As part of Ownr’s Managed Corporation Plan, business founders can get started with Ownr’s customizable template for SAFE agreements today.
Final thoughts
If you’re considering your funding options as a new business owner, a SAFE can be a great option, though it’s important to understand their impact on the cap table to avoid diluting the business. For investors, the attractive terms of a SAFE agreement can be an enticing trade-off despite the potential risks.
What is a SAFE Agreement FAQs
Here are some frequently asked questions and answers about SAFE agreements.
Is a SAFE Agreement a loan?
No, a SAFE agreement is not a loan.Instead, it is a contractual right to future equity. Unlike a loan or convertible note, a SAFE agreement has no interest and no maturity date. Because of this, investors do not make more over time; rather, it is the terms (ie. the valuation cap and discount) of the SAFE agreement at the outset that will determine what their initial investment will pay out.
Are SAFE Agreements beneficial?
SAFE agreements were developed to be mutually beneficial to both the investor and business founder. They are beneficial to a business owner because they are an uncomplicated way to raise capital during the initial growth phase. They are also beneficial because there is no interest or maturity date, so they allow the business to focus on growth without worrying about immediate repayments.
For investors, SAFE agreements are a high-risk investment as it is possible they will never convert into equity if the trigger point is never reached.
Can a SAFE be broken?
SAFE agreements are legally binding documents and cannot be broken, but it is possible that a SAFE agreement never converts to equity. If this happens, the SAFE investor is entitled to repayment upon the dissolution of the company, if such assets still exist.
This article offers general information only, is current as of the date of publication, and is not intended as legal, financial or other professional advice. A professional advisor should be consulted regarding your specific situation. While the information presented is believed to be factual and current, its accuracy is not guaranteed and it should not be regarded as a complete analysis of the subjects discussed. All expressions of opinion reflect the judgment of the author(s) as of the date of publication and are subject to change. No endorsement of any third parties or their advice, opinions, information, products or services is expressly given or implied by RBC Ventures Inc. or its affiliates.