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Startups face a unique obstacle in regard to funding. They need funds to build their product or offering, test it, and release it to customers before they can generate income. But without any performance metrics or other proof they will be successful, startup founders have a hard time convincing investors to risk money on their relatively unknown companies.
Tougher still is the challenge of attempting to evaluate how much a brand new startup might be worth. There’s little basis for any valuation estimates, so the startup and its investors may disagree on how much a company is worth in its early stages.
See also: How To Raise Pre-Seed Funding For Your Startup
This disagreement would normally throw a large wrench in the gears of the early-stage fundraising process. But in an effort to find a solution, some startups have begun offering a different type of investment opportunity, known as a SAFE agreement.
Use this guide as a starting point for learning about SAFE funding—what it is, how it works, and whether it could work for your business.
Important Things Startups Should Understand A SAFE Agreement
What are SAFE agreements?
Sometimes also called a SAFE note, a Simple Agreement for Future Equity (SAFE) is a legally binding contract between a company and its investors who agree upon the exchange of cash investments now in return for future shares of the company.
SAFEs are a method for obtaining crowdfunding from several smaller-level investors at once, rather than trying to convince one or a handful of major investors to contribute large amounts of cash up front.
SAFEs are comparable to convertible notes with the exception that they are not a form of debt. SAFE agreements also lay out specific terms under which investments will be converted to equity, whereas convertible notes typically allow for varying terms.
How does a simple agreement for future equity work?
It’s a fairly common situation for a startup to need funding but lack the valuation and performance metrics investors would typically want to see before contributing money.
Instead of spending a considerable amount of time and effort figuring out what the startup’s value might be in the earliest stages, the startup and its SAFE investors can agree to defer the valuation into the future, until the company has had a chance to grow, gain traction, begin producing revenue, and generate some meaningful data in terms of performance.
If all goes according to plan, the company benefits from receiving early stage funding that would have otherwise been difficult to obtain. In turn, the investors can, in the future, convert their cash contributions into equity and ownership in a now-profitable company.
What components are included within SAFE agreements?
There are a few items that should be included in every SAFE investment contract so both companies and investors understand their rights and responsibilities as the company grows (or does not grow). These components are:
- The terms under which the investment will convert into equity
- The rights of the company to repurchase contributions instead of turning them into equity
- The rights of the investor in the event the company dissolves or otherwise cannot continue
- The rights and responsibilities of investors to vote or have a say in the direction of the company
- A valuation cap that serves as a maximum amount for calculating how much equity an investor will receive
- Any discount applied to the amount the investor pays, in comparison to how much future investors will pay
- Any provisions that allow investors to contribute to future funding rounds
Why is it so important to negotiate SAFE contracts carefully?
SAFE agreements are supposed to be simple. After all, that’s what the “S” stands for. However, the repercussions for entering too lightly into a binding contract can be felt for years to come. Before signing anything, take an in-depth look at each component’s terms within your contract. Not all the components listed above will apply to every SAFE agreement, and sometimes rights may vary. If these terms are not clearly defined and understood by both parties, unpleasant surprises can pop up for investors and companies alike.
The terms of conversion, for instance, vary widely from company to company, and may disappoint unsuspecting investors. Let’s say our example startup company found enough SAFE investors to get off the ground. When investors contributed their money via SAFE agreements, they had hoped that, eventually, the company would reach a point where a specific event triggers conversion of the SAFE notes into shares of the company.
But this triggering event could be almost anything: the company’s acquisition by another entity, a major merger, the point where the company begins offering securities publicly, or any other scenario outlined in the original SAFE agreement contract.
If an investor contributes $10,000 through a SAFE, that investment will theoretically convert into an equivalent number of shares based on the valuation of the company after the triggering liquidity event has been reached. But if, for example, the contract states that SAFE conversion will occur after the company is acquired by another entity, and that never happens, then the triggering point is never reached and every contributing investor is left empty-handed.
Similarly, startups need to take care which terms they include in their SAFE contracts. Something that seems harmless in the beginning stages may come back to bite the company down the line.
If, for example, the original contract allows investors pro rata rights to contribute to future funding rounds, that could create scenarios where a handful of SAFE investors all want exclusive rights to fund a round, but the company has already granted rights to every SAFE investor.
Similarly, the valuation cap can also spell trouble for some companies. Investors usually want a valuation cap included within a SAFE note’s terms in order to reach a certain amount of equity after conversion. If an investor contributes an amount that he or she expects to be worth 5% of the company, but the company then surpasses that goal and becomes wildly successful, the investor will be unhappy to learn that their percentage of equity is actually far lower than planned. The valuation cap ensures that an investor’s conversion rate is based on a predetermined value that guarantees their desired equity percentage, even if that value is far lower than the company’s true value at the time of conversion.
These issues represent a tiny slice of the potential issues that could arise if a SAFE contract is not well implemented. To avoid future trouble, it’s important for investors and companies to thoroughly examine, understand, and agree on terms before proceeding.
How do you know if your startup should pursue a SAFE agreement?
SAFE agreements offer a simpler alternative for obtaining seed funding in comparison to other options like convertible notes, which are notoriously more complicated. Because SAFEs don’t have a set maturity date or any interest rate attached, they are considered relatively straightforward in most cases. Therefore, if you need seed funding and you want to keep things simple and interest-free, SAFEs might be your best bet.
However, resist the temptation to gloss over the details and simply fill in the banks of an agreement you don’t fully understand. If you have only a vague idea of what you’d like your valuation cap to be, how steep of a discount you’re willing to offer investors, or how to negotiate for better terms, it may be a better idea to go with other investment options or let a professional finance team take the reins.
Overwhelmed with the seed funding stage? Get expert guidance from Zeni.
If you’ve already stumbled across the idea of using SAFE agreements to secure early stage funding for your startup, you might have found this article as you’re looking for ways to jump right in. After all, the acronym SAFE (Simple Agreement for Future Equity) implies that investments should be relatively, well, safe.
Unfortunately, as you’ve seen above, this isn’t always the case.
Startups need a thorough lawyer and seasoned, dependable startup finance expert in their court to navigate the SAFE agreement process with confidence. Zeni works with startups and early-stage companies on a daily basis to manage day-to-day financial operations, share real-time financial metrics and insights, and keep financial records in compliance, so you’re ready for any fundraising discussions that may arise at a moment’s notice. When in doubt, you can always reach out to our expert team for guidance.
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