Introduction to SAFE (Simple Agreement for Future Equity)

A SAFE (Simple Agreement for Future Equity) is a legal agreement used in startup funding, designed to allow investors to invest in a company in exchange for the right to future equity. It was introduced by Y Combinator in 2013 as a simpler, more founder-friendly alternative to convertible notes.

Here are some few key points about how it works in a Financial Model

1. Investment in Future Equity: When an investor provides funds through a SAFE, they don’t get equity immediately. Instead, the SAFE converts into shares of equity when a future financing event occurs, such as a priced funding round or acquisition.

2. No Interest or Maturity Date: Unlike convertible notes, SAFEs don’t accrue interest and don’t have a maturity date. This makes them simpler because founders don’t have to worry about repaying the investment or negotiating extensions.

3. Conversion Terms: SAFEs often include a conversion discount (allowing the investor to get equity at a lower price than new investors in the future round) or a valuation cap (which sets a maximum valuation for converting the investment into equity).

4. Founder-Friendly: SAFEs are generally viewed as being more straightforward and less burdensome for startups, as they involve fewer negotiations and legal complexities compared to other funding mechanisms like convertible notes or equity financing.

 How SAFE (Simple Agreement for Future Equity) Agreements Work in Equity Financing

In equity financing, a SAFE (Simple Agreement for Future Equity) agreement is a mechanism that allows investors to fund a startup in exchange for the right to receive equity at a future date, typically when the startup undergoes a future priced equity round. Here’s how it works step-by-step:

1. Investor Provides Funds

• Investors provide capital to the startup, but unlike traditional equity financing, they don’t receive shares immediately. Instead, the investment is structured as a future claim on equity.

2. No Immediate Equity Issuance

• A SAFE agreement does not assign a specific number of shares at the time of the investment. Instead, the investor’s capital is converted into equity at a future event, usually the next priced equity round (i.e., a round where the company’s shares are formally valued).

3. Conversion Triggers

• The SAFE converts into equity upon a triggering event, such as:

• A future equity financing round: When the company raises funds through a traditional equity financing round with a set valuation.

• A liquidity event: If the startup is acquired or goes public, the SAFE may convert to equity or result in a cash payout based on the terms of the agreement.

4. Terms that Impact Conversion

SAFEs often include key terms that affect how much equity the investor receives:

• Valuation Cap: This sets a maximum valuation at which the investment can convert into equity, allowing the investor to benefit from an early, potentially lower valuation.

• Discount Rate: The SAFE may include a discount (e.g., 15-20%) on the share price in the future equity round, meaning the investor gets shares at a lower price than new investors.

• Most Favoured Nation (MFN) Clause: This ensures that if the company later offers more favourable terms to new investors, earlier SAFE investors can receive the same benefits.

5. No Maturity Date or Interest

• Unlike convertible notes, SAFEs do not have a maturity date, so there’s no pressure for repayment or conversion by a specific time. They also do not accrue interest, making them simpler to manage.

6. Conversion Calculation

• At the time of the next equity financing round, the amount invested through the SAFE is converted into equity at a price determined by the valuation cap or discount rate. For example, if an investor put in $100,000, and the valuation cap was $5 million, the investor’s $100,000 would convert into shares as if the company were valued at $5 million, even if the actual valuation is higher.

7. Founder-Friendly Structure

• SAFEs are often considered more founder-friendly because they don’t place as much pressure on startups in the early stages compared to traditional debt financing or convertible notes. There’s no repayment obligation, no interest, and no fixed maturity.

8. Equity is Issued at Financing Event

• Once the triggering event occurs, such as a priced round or acquisition, the SAFE investment is converted into equity, and the investor becomes a shareholder in the company, based on the agreed-upon terms.

Example of How It Works:

• An investor gives a startup $100,000 under a SAFE with a $5 million valuation cap and a 20% discount rate. Later, the company raises a Series A round, valuing the company at $10 million. Since the valuation cap is lower, the investor’s SAFE will convert as if the company’s valuation were $5 million, allowing the investor to receive more equity than they would have if they had invested at the Series A valuation.

Conclusion:

SAFE agreements offer a simple, flexible way for startups to raise funds without the complexity of traditional equity or debt financing. Investors provide funding with the expectation of future equity, and founders benefit from less immediate financial pressure while still securing critical early-stage capital.  

FBS