What is a SAFE?
- Definition: A SAFE (Simple Agreement for Future Equity) is the instrument startups most commonly use to raise capital. It is an investment agreement under which the investor invests money in the company now in exchange for future shares in the company.
The main benefit is that it allows the company to obtain financing quickly and easily, while offering the investor more favorable terms for acquiring shares than those available to investors who join a financing round.
Advantages of a SAFE
- Speed and simplicity: They are much faster and easier to negotiate and sign than a traditional investment round (equity round). Less paperwork and lower legal costs.
- No debt: Unlike convertible notes, SAFEs are not debt. There is no interest and no maturity date. This is crucial for startups that do not want the pressure of debt.
- Benefits for investors: They give investors the opportunity to enter the company at a more favorable price than investors who join in later rounds.
- Flexibility for the startup: They allow startups to raise funds without having to set a precise company valuation at an early stage, when doing so is very difficult.
Why SAFEs instead of SPAs (Share Purchase Agreements)?
SPAs are used for equity, where shares are sold now and a valuation is set now. SAFEs are for an earlier stage than that. They do not grant equity immediately, preventing investors from joining the cap table and therefore making decisions at the company until the SAFEs convert.
What does it mean to sign a Term Sheet or LOI before signing a SAFE?
Before signing a SAFE, it is common to sign a Term Sheet or an LOI. These documents are not binding (except for certain specific clauses), but the investor's reputation is at stake, so unless there is just cause for not honoring them, the investor will do so.
Although SAFEs are standard international documents, some of their clauses and terms are still subject to negotiation between the parties. That is why it is important to have a Term Sheet or LOI setting out the terms to guide the negotiation of the SAFE and the conversion process.
Usual Term Sheet clauses:
- Investment Amount: How much money the investor will invest.
- Valuation Cap.
- Discount Rate.
- Conversion Event.
- Pro Rata Rights.
- Non-shopping clause: The startup agrees not to seek other investors for a set period while negotiating with this investor. This is a binding clause, even if the Term Sheet itself is not.
Types of SAFE: Pre-money vs. Post-money
It is important to understand that in both cases, the investor's ownership percentage is calculated only at the time of the conversion event and before accounting for any other investment in the equity round.
Pre-money SAFE
- Pre-money SAFE: The percentage calculation does take into account all SAFEs (and convertible notes, if any) issued before the equity round. To calculate the Valuation Cap, the company's valuation before the SAFE investment is used, along with all SAFEs issued up to the equity round. That is why it is “pre-money”: the company's valuation before the SAFE is used, and then all SAFEs issued are added.
The main feature (and source of confusion) of a pre-money SAFE is that everyone holding shares or rights to shares before the equity round (founders, investors with pre-money SAFEs, and employees with stock options) is diluted proportionally when the equity round takes place.
- Simplified example:
- The startup has 1,000,000 shares.
- Investor A invests $100,000 with a pre-money SAFE and a valuation cap of $1 million. Theoretically, they would own 10%.
- Investor B invests $100,000 with another pre-money SAFE.
- Now, the founders are diluted by both SAFEs.
- The equity round takes place. Everyone is diluted (the founders, Investor A, and Investor B). Investor A will convert their shares at a Valuation Cap of $1,200,000.
- That Valuation Cap is what we use to determine the value of each share: $1,000,000/$1,200,000 = $1,2 per share. This gives Investor A $100,000/$1,2 = 83,333 shares (8,3% of the company)
- Advantage: Greater flexibility for the startup at the outset, and less dilution for the founders.
- Disadvantage: It is harder for investors to calculate their exact percentage, and for founders to maintain an orderly cap table and know how much of the company they are selling.
Post-money SAFE
- Post-money SAFE: The percentage the investor will receive is calculated after taking into account their own investment, but before any other subsequent investment (including other SAFEs). Founders are diluted with each SAFE, but post-money investors do not dilute one another; they are diluted only by the equity round.
- Advantage: Greater clarity for investors about their ownership percentage. Less dilution and greater predictability for founders with each new SAFE (although they are diluted more in the equity round).
- Disadvantage: Less flexibility for the startup.
Which is more common and preferred by investors? SAFEs post-money are becoming increasingly common because they offer investors greater transparency.