From debt to equity, rewards and donations the crowdfunding world has many different avenues for companies to raise capital. In the following post we will look at the crowd SAFE, examine how it works, and provide some insight for potential investors.
A Simple Agreement for Future Equity (SAFE) is a financial instrument used by angels and VCs when investing in startups and is intended to replace convertible notes. The SAFE allows individual investors to contribute capital to a company and benefit from any upside realized during an IPO or acquisition. The investment does not buy stock in the company right away. If a “triggering” event takes place (i.e. IPO or acquisition), then the capital invested turns into equity. Due to this feature it is important to state that SAFEs are not a debt instrument and do not have maturity dates or accrue interest. When accounting for SAFEs on a company’s cap table it is treated like a convertible security, such as an option or warrant.
One important feature of the SAFE is that it was designed to be a standardized security. Only a few items should have to be negotiated, the most important of which is the valuation cap. With a standardized security costs borne by issuers and investors can be significantly reduced, as can the time to close.
How Does a SAFE Work?
When investing in a SAFE, the investor(s) do not receive equity at first. They receive an agreement stating that their investment will convert to equity upon specified “triggering” events. Such triggering events may include a round of equity financing, an acquisition, or an IPO. Typically, investors will receive pro rata rights when they become shareholders unless they fail to meet specific terms of the Equity Financing document, such as dollar threshold requirements.
Similar to other securities, various flavors of SAFEs can exist. The following are some of the more popular options that investors and startups may encounter.
Cap and Discount
This is a SAFE with both a valuation cap and discount rate. When converting the SAFE into shares of stock only the cap or discount rate will be used, but not both. The valuation cap will stipulate the maximum amount at which an investor’s capital will convert into equity shares. For example, if a company is acquired for $40M but the SAFE’s cap was $20M, the investor will buy shares as if the company is worth $20M. The discount rate grants investors equity shares at a discount to what others are paying in the IPO or acquisition. For example, a 10% discount means the investor will receive their investment worth of shares 10% cheaper than face value.
Discount, No Cap
This style of SAFE will have an agreed upon discount rate, but no cap. When the SAFE is converted the investor has the option to have the purchase amount repaid or receive shares of common stock at the fair market value with the discount rate applied.
Cap, No Discount
Similar to the discount, no cap scenario except now the investor has negotiated for a valuation cap and no discount rate.
The SAFE is a relatively new financial instrument that started being used in equity crowdfunding after the SEC allowed individual investors to participate in securities crowdfunding in 2016.
The following are a few points to remember before investing in a SAFE. As always, if you have questions consulting a lawyer or experienced investment adviser is a wise course of action.
The question is not as simple as it appears. The SAFE has both pros and cons for issuers and investors alike. The ability to close funding rounds sooner and with potentially lower legal costs are benefits to cash-strapped startups. However, founders can end up running into serious problems if they are not diligent in how they issue SAFEs. One potential problem is that founders don’t accurately calculate their personal dilution that will take place when the SAFEs convert into equity. If multiple rounds of SAFEs are issued the founder might have the unpleasant surprise of learning that they own less of their company than they would like once an equity round is priced. A cap table full of SAFEs at various valuations may also make it difficult, if not impossible, to raise VC funds in the future.
Prior to issuing SAFEs founders should do their research and know what they are getting into. Like any security, the pros and cons of issuance and investment must be weighed so that an educated decision can be made.