A relatively new tool has come into founders’ hands: simple agreements for future equity, or SAFEs. But are they, as the name suggests, simple? Not necessarily.
They’re still worth wrapping your head around, though, because SAFEs could give you a way to get the financial backing you need with less risk to your company.
Introduced by Y Combinator in 2013, SAFEs are legal contracts that serve as an alternative to convertible notes. They let you issue someone rights to future equity without putting debt on your books.
Sound good? Let’s look more closely to find out if this tool could be right for your startup.
How simple agreements for future equity work
Under a SAFE, you give an investor the right to preferred shares in your company at a future, specified event rather than actually issuing them shares right now. That saves you from having to get a valuation, which is often both challenging and inaccurate for seed-stage companies.
Because you’re only giving the investor the right to equity in the future, the SAFE agreement means you don’t, at that moment, need to issue any equity or take on any debt. Instead, you promise them shares at a future triggering liquidity event, like a round of fundraising or an IPO.
Why would an investor agree to accept what is essentially an IOU in exchange for their money? SAFEs almost always come with some serious investor perks, which we’ll dig into in just a moment.
Those perks can take the investor’s money further, giving them more shares at a better price if/when you do hit that triggering event. For investors willing to take on a high level of risk — a given any time they invest in early-stage companies — the SAFE can streamline things. These agreements are usually, as their name suggests, simpler than convertible notes. They can give investors the opportunity to get in early with a company where they see potential without a lot of negotiation and paperwork.
With SAFEs, you get the investor’s money now and they get a promise for the future. Usually, SAFEs promise to convert the investor’s money into shares at a triggering event like:
- An official equity financing round (e.g., one led by an institutional VC fund)
- A merger
- The sale of the company
- An IPO
While investors wait for that event, the SAFE doesn’t accrue interest. And because they’re not debt, if your company never reaches that triggering event, you don’t need to repay the investor, either. Most SAFEs include a protocol explaining what happens if the company dissolves rather than reaching the event that would convert the SAFE into shares for the investor.
Investor benefits in SAFEs
Generally, to incentivize investors to take on this high risk, SAFEs give them preferred shares. That means the shares usually come with at least one — and sometimes multiple — of these perks:
Valuation caps
While you don’t necessarily need to get your startup officially valued to issue SAFEs, many investors will want some valuation estimate in play. Specifically, they may require a valuation cap.
This is the maximum valuation against which their shares will get issued. So, essentially, if your company ends up getting valued at $20M but your SAFE has a valuation cap of $10M, the investor’s money will buy them twice as many shares as investors coming on board at the triggering event.
The lower the valuation cap, the more favorable the SAFE’s conversion into shares from the investor’s perspective. So be prepared to negotiate here.
Discounts
The discount is just what it sounds like: a percentage your company takes off the top to help an investor’s dollar buy them more shares. Generally, SAFEs offer discounts somewhere between 5–30%. 20% is common.
While some SAFEs include both valuation caps and discounts, you can usually get away with one or the other (or, in ideal cases, neither). Founders usually fare better from a dilution perspective with discounts than valuation caps.
Most-favored nations (MFN) provision
This essentially guarantees that the investor agreeing to the SAFE gets the best deal possible. Under an MNF, if you offer better privileges to another investor (say you issue convertible securities with more favorable terms than the SAFE), those better terms automatically apply to the SAFE.
You might also see MFNs called non-discrimination clauses.
Pro-rata rights
These are less common in SAFEs than the previous three investor benefits, but they can help you land investors who care about having a meaningful ownership stake in your startup.
With pro-rata rights, your investor would get the opportunity to add as much money as is needed in order to maintain their ownership percentage after any fundraising rounds.
The good news? In most cases, SAFE pro-rata rights dictate that the investor pays the current price versus the one that they have through their SAFE. That means that it can offer some serious benefits to your startup, helping you keep good investors involved in a significant way even as you move through rounds of financing.
SAFE benefits for startup founders
Obviously, SAFEs build in perks to lure investors. But they also offer benefits for founders. With a SAFE, you:
- Delay company valuation — SAFEs give you a way to avoid this challenging component of early-stage startups while still having the means to raise capital.
- Avoid interest — Unlike convertible notes, using SAFEs means you’re not accruing interest as you scale up your startup.
- Limit risk — If the triggering event never comes, you’re not liable for what the investor gave you. They have to chalk it up to a loss, and you don’t have to worry about paying it back.
- Buy time — With no attached maturity date, the SAFE gives you the flexibility to move your company forward at the pace that makes sense. You don’t need to rush into fundraising if you want to finesse your product or service first, for example.
One word of caution here: don’t forget that while you’re not issuing shares right now, you are issuing a promise for them. And with factors like valuation caps and discounts in play, you might be offering more than you realize. More than a few founders have found themselves with dilution problems after being overly free with SAFEs. Make sure you’re carefully considering what your equity structure will look like when your company reaches the triggering event for any SAFE notes it issues.
Accounting Perspective
From an accounting standpoint, there is some debate over whether a SAFE note should be classified as a liability or equity on the balance sheet. This is because a SAFE note has characteristics of both debt (a liability) and equity.
However, since a SAFE note does not have a maturity date, does not accrue interest, and does not obligate the company to repay the invested amount, it is more common to classify it as equity, or more specifically, as a type of “equity-like” instrument. To be even more precise, it could be shown as a separate line item within the equity section of the balance sheet, labeled as something like “SAFE notes outstanding” or “Convertible SAFE notes.”
Generally, when a company receives funds from a SAFE note, the journal entry would be as follows:
Debit “Cash” (an asset account) to reflect the inflow of funds from the investor.
Credit a specific equity account, such as “SAFE Notes Outstanding” or “Convertible SAFE Notes” (an equity or liability account), to reflect the liability to issue future equity.
As a relatively new tool at the founders’ disposal, SAFEs hold a lot of promise. They do come with some risks and special considerations, though, so take the time to understand them clearly before you dive in. If you want to talk to an expert about whether or not simple agreements for future equity could be right for your startup, contact us.