What Startups Need to Know about Simple Agreement for Future Equity (SAFE)
As a startup, you undoubtedly go through agreements after agreements with other businesses, vendors, contractors, investors, and many others. One agreement that is less known is the Simple Agreement for Future Equity (SAFE). These agreements can prove significant to a startup’s success, but not all SAFE agreements are created equal.
Mohsen Parsa, a startup attorney in Los Angeles, helps clients understand SAFE agreements, draft comprehensive SAFE agreements for clients, and provide advice and overall direction on these types of agreements so that startup clients can make the best choices for the short-term and the long-term. Here is an overview of SAFE agreements and why they are significant for startups, but if you have specific questions about your SAFE agreements or about entering into these types of agreements, contact Parsa Law, Inc. today.
What is a Simple Agreement for Future Equity (SAFE)?
SAFE agreements are a relatively new type of investment created in 2013 byY Combinator. These agreements are made between a company and an investor and create potential future equity in the company for the investor in exchange for immediate cash to the company. The SAFE converts to equity at a later round of financing but only if a particular triggering event (outlined in the agreement) takes place.
To understand what a SAFE is, it is also important to know what it is not. It is not a debt instrument. It is also not common stock or convertible notes. That said, SAFEs are similar to convertible notes in that they both provide equity to the investor during a future preferred stock round and can include valuation caps or discounts. Unlike convertible notes, however, SAFEs do not accrue interest and do not have a specific maturity date, and – in fact – may never be triggered to convert the SAFE to equity.
How does a SAFE work?
The startup company (or another company) and the investor enter into an agreement. They negotiate things like:
- valuation caps
- maturity date/event, and
- investment amount.
Once the terms are agreed upon and the SAFE is signed by both parties, the investor sends the company the agreed-upon funds. The company applies the funds according to any relevant terms and conditions. The investor does not obtain the equity (SAFE preferred stock) until an event listed in the SAFE agreement triggers the conversion.
In the meantime, a SAFE that has not matured is treated like any other convertible security (e.g., warrants or options).
Why does SAFE Matter to Startups?
SAFEs are used by startups specifically as a new way to raise money. But they can be significant to a startup’s growth because they are:
- relatively easy to create and implement;
- do not accrue interest as a loan does; and
- offers flexibility in the way the company raises funds.
These three points can be instrumental in luring investors to the company. They also involve less risk that often accompanies other types of investments. Plus, SAFEs are something akin to a problem-solver for startup companies. There are a few specific problems that are solved, and these are briefly addressed below.
Debt.Debt is a problem for startups. As the label indicates, these companies are just starting out and trying to find a home in the market. Debt creates stress and can be the end of a company. It can also be a reason startups fail. For example, convertible notes are often used by investors but they are debt instruments. SAFEs are not debt instruments and, as such, remove the threat of solvency. If the company fails, the owners do not have the burden of paying back the investor (but if the company succeeds, in part because it’s not burdened with lots of debt, the investor reaps the benefits alongside the company).
Paperwork.Paperwork is energy- and time-consuming. This is particularly problematic for startup companies because their focus needs to be on growth and scaling up and operations and many other things but no paperwork. When investors, for example, invest using convertible notes, maturity dates are attached to these investments. The problem is this: come the date of maturity, many startups are not ready. As a result, they must request maturity date extensions and that means paperwork on top of paperwork. With SAFEs, however, no extension is required because there is no maturity date.
Legal Costs.Startups require legal direction and counsel so that they comply with rules and regulations relevant to their industry, product, and/or service. They also require legal representation for negotiations and guidance on agreements. Legal costs can add up quickly. Fortunately, SAFE agreements are relatively easy to create compared to things like agreements involving convertible notes.
Standardization.Standardized agreements are a burden because they impose specific standards and require specific terms, clauses, or provisions. Standardization in itself is not a problem because it offers consistency and expectation, but it also denies customization. This is a problem for startups because they are unique and new to the market and customization can help them grow and develop in a way distinct from competitors. SAFEs are not standardized. Terms can be negotiated (to benefit the startup), including terms related to conversion, repurchase rights, dissolution rights, and voting rights.
Control.When investors invest in startups, part of their immediate return on the investment are stocks in the company. Common stocks render voting rights to investors. With voting rights, investors can partake in the shaping of the company. The problem is this: owners of the company often want to keep control of the company’s shaping for as long as possible to make sure their vision materializes as intended. When voting rights spread out among more and more people, that control diminishes. With SAFEs, current equity stakes in the company are not provided, so the investor does not receive stocks and, therefore, does not receive immediate voting rights.
How are SAFE agreements treated under securities laws?
SAFEs are regulated by the SEC under the Securities Act of 1933 and the Securities Exchange Act of 1934. SAFEs are considered securities and are treated just like stocks and convertible notes under California and federal law.
Who should you contact to learn more about SAFE and its benefits for your startup in California?
SAFE agreements have a lot to offer. But what benefits the startup, like the absence of standardization, can also harm the startup if the agreement is not professionally and strategically drafted and negotiated. If you are a startup and want alternative and creative ways to find investors,contact Mohsen Parsatoday.