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Introduced by Y Combinator in 2013, SAFE agreements are increasingly popular as an instrument for initial funding for startups. They are simpler and more founder-friendly than traditional convertible notes and offer greater flexibility for investors. If you are an entrepreneur in the early stages of fundraising, consider meeting with a SAFE financing lawyer to determine whether this instrument is right for you.

What Is SAFE Financing?

A Simple Agreement for Future Equity (SAFE) is a legal contract that grants investors the right to purchase company equity at a future date in return for early seed financing. It can be complex, expensive, and time consuming for an early stage startup to get an accurate company valuation, especially when the company doesn’t have a lot of capital or operating history. Using a SAFE agreement, companies can offer equity at a specified discount or valuation cap, without a contractual maturity date or company valuation, thus streamlining and simplifying the investment process.

Traditional convertible notes represent loans, which include features like a maturity date, interest rate, and repayment obligations. The terms of these agreements can be complex and time-consuming to negotiate, and the ensuing debt can become a costly liability to early-stage companies. SAFE agreements, on the other hand, can be simpler and more streamlined, with transparent and flexible terms that increase access to funding and protect investor rights.

Elements of a SAFE

SAFE agreements are highly flexible, allowing founders and investors to reach the terms that are most important and applicable to the specific startup. As a fairly new funding mechanism, SAFE agreements are also evolving quickly as investors and founders discover occasional drawbacks in previous generations of SAFE financing. SAFE agreements generally include many of the following elements and provisions:

Valuation Cap

The Valuation Cap establishes the maximum valuation at which the investor’s SAFE agreement converts into company equity. It protects the investor by setting an upper limit on the company’s valuation, giving investors a favorable price and avoiding the risk of disproportionate dilution.

Discount Rate

The discount rate in a SAFE represents a percentage reduction applied to the price per share that investors will pay when their SAFE converts into equity. This conversion typically happens during the company’s next major equity financing round, such as a Series A.

Conversion Triggers

The conversion trigger describes the event or milestone at which a SAFE agreement can be converted into equity. Popular conversion triggers include:

Equity Financing. An equity financing conversion trigger specifies that the SAFE automatically converts once the company has raised a specified minimum amount of funding from external investors.
Liquidity Event. A SAFE agreement typically includes provisions for common liquidity events, including an IPO or a merger or acquisition. This conversion event allows the investor to benefit from the liquidity and the potential appreciation of company value.
Dissolution Event. A SAFE agreement also specifies that equity conversion can take place at company dissolution, like a liquidation or bankruptcy. The specific terms of this type of conversion should be carefully considered and negotiated with the help of a SAFE financing lawyer.

Conversion Mechanics

A conversion mechanics provision specifies the process and method for SAFE conversion, helping the process be clear and efficient for all parties. Specific conversion mechanics should be agreed upon for any and all conversion triggers, with a smooth and straightforward process.

Most Favored Nation (MFN)

Many preferred investors are granted Most Favored Nation status as part of the SAFE agreement, protecting them from being disadvantaged in later financing rounds. This provision ensures that should subsequent SAFEs be issued with more favorable terms, these investors are automatically granted those same terms.

Termination

A SAFE agreement specifies the conditions that will terminate the agreement. Typical termination triggers include the conversion of a SAFE into equity or the payment of the amount due in a SAFE at a liquidity or dissolution event. Like the conversion mechanics, the termination provision specifies the circumstances and process by which the agreement ends, avoiding confusion and conflict.

Investor Rights

The SAFE agreement may specify various other investor rights, including the right to information (such as updates, financial data, and other company information), the right to participate in future financing events, and other rights.

Because SAFE financing is so flexible, specific agreements may vary dramatically, and each party can negotiate the terms and provisions that are most relevant to their interests. Founders should always consult with a startup attorney prior to seeking financing using a SAFE or any other fundraising mechanism. It is crucial to work with an experienced SAFE financing lawyer to streamline the negotiation process and ensure that the final agreement is transparent and beneficial to all parties.

Benefits and Risks of SAFE Agreements for Entrepreneurs

SAFE agreements are famous for being founder-friendly and especially beneficial for seed-stage startups. They carry many benefits for entrepreneurs and founders, including:

No company valuation. It can be extremely difficult to create a fair valuation of an early-stage startup, and the valuation is often a point of dispute and contention during early-stage fundraising. SAFE agreements allow companies to defer valuation until a later date when valuation can be more accurate.
No maturity date. A convertible note typically has a maturity date at which the debt is due, but a SAFE instead converts at a triggering event. While, in practice, many investors defer maturity dates on convertible notes, SAFE financing allows companies more time to generate revenue.
No interest rate. Because conversion notes are debt instruments, they accrue interest. SAFE agreements do not accrue interest.
Not counted as debt. Many early-stage founders quickly find themselves under financial pressure due to debts and loans. SAFE agreements are not loans, so they are not financial obligations or liabilities to new companies.
Limited investor rights. A SAFE is not equity, so the investor does not gain equity or voting rights, allowing the founder to retain greater control of the company for longer.
Greater investor alignment. Because a SAFE agreement directly ties investor incentives with company success, it helps to create a greater alignment of interests between founders and funders and builds more cooperative relationships.
More affordable financing. Because SAFEs are not debt instruments, they have fewer regulations than convertible notes. Because of the simplicity and streamlined terms, the alignment of interests, and the reduced regulatory burden, SAFE financing has lower legal costs and is more affordable to access.

The biggest risk of a SAFE for a founder is the risk of overvaluation. If a startup struggles to reach its benchmarks, and relies on SAFEs for most of its funding, a founder may discover that, upon conversion, their stakes are significantly diluted. While this is always a risk for a startup, the deferral inherent in SAFEs may allow more dilution than anticipated.

Are SAFEs Attractive to Investors?

Because SAFEs are not debt, they pose greater risks to investors, and institutional investors, in particular, may seek special provisions that protect their interests. Without a maturity date or interest rate, investors run the risk that a conversion event may not happen, and they will lose their money. Additionally, the IRS has not provided clear guidance on whether SAFEs will qualify as a Qualified Small Business Stock (QSBS), which may discourage some investors.

However, despite these drawbacks, many investors are still attracted to SAFE agreements. Their simplicity, flexibility, and adaptability allow them to meet a wide range of needs and create new opportunities. The cooperative nature of a SAFE also allows founders and investorsto easily agree on the terms that work best for them.

Need Legal Help? Reach Out to the Fridman Law Firm

If you are an early-stage founder seeking a SAFE financing lawyer or simply have questions about financing and fundraising, contact the Fridman Law Firm today. We offer a range of services to help entrepreneurs grow quickly, and we are passionate about your success. Call 212-262-9823 for a consultation.