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.
