Why do you need a SAFE?

Introduction

When project founders want to attract investors, they have several ways of financing. Among the most common methods are investments (i) based on a combination of Term Sheet and Shareholders agreement, (ii) in the form of a convertible note agreement, (iii) in the form of a SAFE. 

What is a SAFE (Simple Agreement for Future Equity), what is its feature, and how to choose the option that is best for both parties — we will analyze it below.

Kind reminder

Just to remind you, there are different stages of financing. The methods of formalizing investments will also vary depending on the stage.

  • Pre-seed round
  • Seed round
  • Series A
  • Series B
  • Series C
  • IPO

Seed round and series A, B and C are considered 4 official stages of funding.

All of these stages raise gradually more money. However, less than 10% of startups that have received seed funding continue to raise capital in Round A financing.

Pre-seed round

This is the initial stage of financing. At this stage, an idea is formed, hypotheses are tested, and developments are made to prepare for the launch of an MVP (minimum viable product). As a rule, at this stage, the source of funding is often the founders’ own savings, as well as funds from relatives, friends, and like-minded people (this period is called FFF-investing, where FFF stands for Friends, Fools, Family). But very often the money raised is not enough, and the project needs external investment.

If friends and like-minded people invest in a project, this is often formalized in the form of a Terms Sheet, which states that its provisions are binding on the parties and should be included in the Shareholders agreement.

Traditionally, the Terms Sheet is considered a non-binding document, but to protect the interests of investors, the document states that it causes obligations for its participants. In addition, there are many examples where the Terms Sheet has been recognized as a binding document.

If we want to attract an external investor, the Terms Sheet + Shareholders agreement may not be enough, since the project is only at the idea stage, and the investor may not be sure that he will not lose his money. In this regard, a convertible note is often used. This document allows you to either repay the loan amount with interest or convert it into a share in the company’s capital. This option is safer for investors, but many founders do not want to use this method of investment because it creates a debt obligation and the project may not bring the expected result.

Seed round

This is the first official stage of attracting investment. The project already has a company and a business plan. The project is still very risky, but the founders already have more specifics about further development and the launch of MVP. Business angels join the FFF of investors.

Business angels are investors who provide financial assistance to companies at an early stage of their development. Such investments are associated with high risks.

Their mission is not only professional investment in potentially profitable projects, but also mentoring and coordination of promising projects.

Since the project is still at an early stage, it is difficult to evaluate it in order to distribute equity shares after the investment. The project is promising, and the founders do not want to lose even a little more equity than is necessary to attract an investor (remember that there may be several rounds of funding, and with each round, the founder’s share will be diluted). In turn, it is also important for the investor to have a realistic assessment of the project so as not to overpay for an equity stake. In addition, if the project does not work out, but shows a lower result than expected, investors want to get the most out of their investment, and the return of the loan amount with interest may be too insufficient for them. In this regard, the parties are looking for additional ways out of this situation. A good solution is to sign a SAFE agreement.

Series A, B, C

At this stage, SAFE is unlikely to satisfy investors, as the next round of financing may not take place, or the next round will be after a long period of time. Therefore, investors turn to more traditional instruments, such as a convertible note.

How to make an investment anyway?

A great but still risky option is to sign a SAFE. This will allow you to postpone the valuation of the company until a later stage. SAFE is beneficial for founders because it is not a debt obligation, has no interest and no maturity date, and such an agreement allows them to retain their stake in the company for a certain period of time. 

In addition, a typical financing round requires a lot of coordination to align investors, sign documents, and transfer money on the same closing date. With SAFE, projects can close the deal with an investor as soon as both parties are ready to sign the document and the investor is ready to transfer the money. 

The advantage of the SAFE is that it is a fairly standardized document that is small in size, which saves time in negotiations and allows you to quickly attract investment.

However, investors may be left with nothing. SAFE is not suitable for investors who expect to be reimbursed for their investment in case of failure. 

It is worth noting that most professional early investors understand the risks of investing in early-stage projects. The number of SAFEs signed indicates that investors are willing to invest in this way, as it can provide a number of benefits. What are these advantages? Let’s analyze them.

How does SAFE work?

In short, in subsequent investment rounds, SAFEs are converted into shares: the investor receives shares in the company in exchange for his or her investment. Depending on the type of SAFE, these values may differ, let’s look at this in more detail.

What are the types of SAFE?

First of all, it is worth noting that there is Post-money SAFE and Pre-money SAFE. In Post-money SAFE, all SAFE transactions entered into by the founders are used for the calculation. At the same time, Pre-money SAFE does not use the funds received under SAFE agreements to calculate the company’s valuation, so investors cannot predict how their share in the project will be diluted. Therefore, we recommend using Post-money SAFE. At the same time, this type of SAFE is divided into certain other types.

  • SAFE: Valuation cap, no discount
  • SAFE: Discount, no valuation cap
  • SAFE: Valuation cap and discount
  • SAFE: MFN, No valuation cap, no discount

Let’s look at certain concepts to better understand the SAFE mechanism:

Valuation cap: the company’s valuation limit is the maximum valuation that is taken into account when calculating the investor’s share. The real valuation may significantly exceed this cap, but in this case it will not be taken into account, since the higher the real valuation, the lower the investor’s share (in the absence of a cap).

  • Valuation cap: the company’s valuation limit is the maximum valuation that is taken into account when calculating the investor’s share. The real valuation may significantly exceed this cap, but in this case it will not be taken into account, since the higher the real valuation, the lower the investor’s share (in the absence of a cap).
  • Discount: discount rate. This is the amount of discount the investor receives on the share price upon conversion.

1. SAFE: Valuation cap, no discount

Keep in mind that SAFE allows you to postpone project valuation until the next round of financing. That is, when the next investment is made, the company’s valuation will be determined, from which the investor’s share will be calculated.  

Let’s assume that the investor invested $100,000 and the company’s valuation was $1,000,000. In this case, the investor will receive a 10% equity interest.

Why Valuation cap and how does it work?

Keep the initial data unchanged, but add that the Valuation cap is $500,000. In this case, the share owned by the investor will be calculated based on this maximum valuation: ($100,000/$500,000) x 100% = 20%.

That is, the investor’s share in the project will be 20%, despite the fact that the company is valued at $1,000,000.

If the valuation did not reach the Valuation cap?

If the Valuation cap is set at $500,000, and the company’s valuation following the next investment round is $400,000, then the calculation of the investor’s share will be based on the amount of $400,000, as it is more profitable for the investor: ($100,000/$400,000) x 100 = 25% – investor’s share.

2. SAFE: Discount, no valuation cap

According to this type of SAFE, the investor receives shares worth the amount of his investment at a discount upon the conversion event.  In this case, the entire valuation of the company during the relevant round is taken into account  for calculation.

How does it work?

Assume that SAFE has a discount of 80%. The initial conditions are unchanged: the investor has invested $100,000 in the project, and the project valuation is $1,000,000. 

If there were no Discount, the investor would receive a share of 10% If we set the Discount to 80%, the investor will receive: ($100,000 / ($1,000,000 x 80%))x100% = ($100,000 / $800,000)x100% = 12.5%.

3. SAFE: Valuation cap and discount

This type of SAFE utilizes a valuation cap and a discount. The method for conversion that is most favorable to the investor is used. Initial conditions:

  • Investment – $100,000
  • Valuation cap – $500 000
  • Discount – 80%.

Option 1 – the company’s valuation has reached the Valuation cap and is $1,000,000

Valuation cap

In order to calculate the Investor’s share, the Valuation cap will be taken as 500,000. Therefore, the investor will receive 20% in the company.

Discount

Since the Discount is 80%, the investor will receive: ($100,000 / ($1,000,000 x 80%))x100% = ($100,000 / $800,000)x100% = 12.5%.

Option 2 – the company’s valuation has not reached the Valuation cap and is $300,000.

Valuation cap

In order to calculate the Investor’s share, the company’s valuation will be taken as $300,000. ($100,000/$300,000) x 100 = 33.33%.

Discount

($100,000 / ($300,000 x 80%)) = ($100,000 / $240,000)x100% = 41.66%.

Result

As we can see, the results are quite different – various SAFE options provide different benefits to investors. If you set the Valuation cap and the project exceeds all expectations, the investor will be able to get a significant stake in an attractive company. Based on the example above in section “1. SAFE: Valuation cap, no discount”, we see that the value of an investor’s share can be 2 times higher than his (or her) initial investment, but it should be remembered that everything depends on the specific circumstances. If we use Discount, we can see that in some cases it at least recoups the investor’s investment and provides a much higher return than the usual interest on debt.

What are the risks of SAFE?

  1. The conversion event may not occur, and the project may not attract new rounds of investment. It is worth adding that the standard SAFE provides for special conversion procedures in the event of a company’s liquidation, termination of operations, or sale of the company. However, it is worth emphasizing that this may not happen.
  2. There is no minimum threshold for a future round of investment for conversion. That is, the company can attract insignificant investments, and the SAFE will be convertible. In this case, the investor will not receive a much larger share than his investment. At the same time, this can also be a issue for the founders when they receive a new shareholder (or group of shareholders) at an early stage.

How to protect the interests of the investor?

It is worth conducting proper project due diligence. Employees may not be employees, just independent contractors formalized for another company, and all assets are either owned by the founders or other legal entities that are not related to the project. 

It is also necessary to assess the company’s growth indicators (not all of them may be applicable to early projects, but nevertheless, they can give an idea of whether the project is really developing in the right direction and not attracting investments just to close the “holes” in the budget and survive in the market).

In addition, it is worth considering options similar to SAFE, such as KISS (Keep It Simple Securities).

What is KISS (Keep It Simple Securities)?

This document is somewhat similar to the SAFE, but contains one of the main differences – in the standard document, after 18 months, the SAFE turns into a Convertible note. In other words, KISS removes the main drawback of SAFE – the possible non-occurrence of a conversion event.

Comparative analysis of financing tools

SAFE KISS
Valuation cap depends on the type of SAFE +
Discount depends on the type of SAFE +
Priced equity round conversion regardless of size conversion only if the next round exceeds $1,000,000
Maturity date 18 months
Interest 5%
Class of investors There is a class of investors called the “big investor” – someone who has invested at least $50,000. Large investors are granted certain rights to receive information (financial and not only).
Sale of company Option to (i) receive a payment equal to the initial investment or (ii) convert to common shares within a specified limit The ability to (i) receive a payout in multiples of the initial investment or (ii) convert to common shares within a specified limit
MFN clause can be additionally designed +
Transferability the investor may transfer only to affiliates the investor can transfer to anyone

Conclusion

Choosing the right investment agreement is important for both startup founders and investors. A SAFE agreement provides simplicity and flexibility, but investors may be effectively deprived of their investment if the conversion event does not occur. This disadvantage can be eliminated by a KISS agreement, but not all founders are willing to agree to it. In any case, you need to remember that every investment transaction involves risks, and qualified lawyers can help you mitigate them.

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