Tuesday, March 14, 2017

Cracking the SAFE: Financing Option for Start-ups

What the heck is a SAFE start-up investment and is it right for you?

SAFE stands for Simple Agreement for Future Equity.  The investment approach and the acronym itself were developed and coined by Y Combinator, a Silicon Valley-based start-up accelerator and seed investor. SAFEs have been getting quite a bit of buzz in the start-up community.

A SAFE is a convertible equity instrument used by start-up companies. The investor invests cash today in exchange for the company’s promise to issue equity in the future. What type of equity and upon what terms?  Exactly.  SAFE’s are convertible into the next round of equity issued by the company (typically a Series A preferred stock financing round) - whatever that financing round ends up looking like. SAFEs typically convert at a price discount to the Series A round and/or with a valuation cap applicable to the Series A round so that the early stage SAFE investor gets some benefit from taking on more risk by investing in the company at an earlier stage.

Here’s how it works.  Say you have a start-up company that has a great idea but urgently needs funding (sound familiar?).  You have some friends and family or angel investors that have bought into the concept and your vision, but because the company is early-stage, pre-revenue, there are no obviously appropriate valuation metrics.  The company needs equity financing sooner rather than later, but how do you price the equity at such an early stage? Whatever valuation you pick is likely to be unfair to the founders or the investors. And what other equity terms will apply (common or preferred equity, liquidation preference, dividend rate, registration rights, tag-along rights, board membership rights, voting rights, etc.)? As you can see, when you start funding a start-up, a lot of questions arise quickly.  Does it really make sense to spend a start-up’s limited time and money negotiating valuation and other deal terms at such an early stage? The parties could spend thousands of dollars and countless hours putting deal terms in place for a concept that never gets off the ground.

The SAFE investment instrument allows you to kick these sorts of issues down the road to a more appropriate stage of the start-up’s life cycle. When the start-up engages in a true Series A financing round, perhaps the financing round led by more sophisticated professional investors, such as a venture capital firm. Often the Series A investor is better able to take on the task of valuing the company and structuring the terms of the Series A investment. And perhaps the company has a revenue stream to value or at least a clearer path to defining and measuring a potential revenue stream at that point. When things go as planned, the SAFE investors can piggy-back off the added time, information and expertise of the Series A investors to hopefully achieve more equitable deal terms. The SAFE converts into the same (or substantially similar) security purchased by the Series A investors at the same time the Series A round closes.

If SAFEs sound familiar, it’s because SAFEs are in many ways similar to convertible notes, which have long been a tool used by early-stage start-up investors. SAFEs, like convertible notes, involve a cash investment today with an expectation of conversion in an equity security in the future.
Advocates for SAFE, such as Y Combinator, argue that SAFEs are superior to convertible notes because, among other things (1) SAFEs accrue no interest, (2) SAFEs have no maturity dates, and thus, no potential solvency issues for the start-ups, (3) SAFEs have fewer terms to negotiate, and thus are less expensive to implement (a SAFE is typically only about 5 pages long), and (4) SAFEs are more reflective of economic reality – investors in convertible notes rarely really intended to be a lender to the company (the convertible note is just a placeholder until conversion, typically when the Series A terms are known).

There is much positive to be said for SAFEs as a quick-and-dirty mechanism to bridge a start-up to a more formal round of equity financing. From the company’s perspective, there is much to love about SAFEs.

From the investor’s perspective, on the other hand, SAFE is a misnomer. The instrument isn’t “safe,” or at least not as safe as a convertible note or a priced equity financing round. If the start-up never issues it’s “next” round of equity, the SAFE exists in investment purgatory as neither an equity investment nor a loan. SAFEs typically provide that SAFE investors get a liquidation preference or get converted into equity upon a sale or liquidation of the company – but that could be many years down the road – or never!  Of course, no start-up equity investment is truly safe. If the company fails spectacularly, a convertible note holder is likely to be every bit as “wiped-out” as a SAFE holder. Still, there are advantages to an investor having the status and rights of a lender or a true equity holder.

That said, a SAFE investor could reasonably conclude that the cost savings to the investor (and to the company) of investing in a SAFE might outweigh the added investor protections of negotiating to acquire convertible notes or a full-blown common or preferred equity investment.     

While the SAFE investment vehicle is not for everyone, it is certainly a worthy addition to a start-up’s financing tool-box.

SAFE form documents proposed by Y Combinator are available on their website here.

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