Simple agreements for future equity ("SAFEs") are becoming a common way for startups and high-growth companies to raise funds.
However, don't let the name fool you. While SAFEs may be intended to be a simple and quick way to bring money in the door, the terms of SAFEs are much more complex and tend to kick a number of uncertain terms down the road (so to speak).
Small modifications to the terms of a SAFE can have a big impact on a company's capitalization table, dilution of founder shares and an investor's bottom line. For this reason, you should always consult with your own legal advisors when considering issuing or purchasing a SAFE.
What is a SAFE?
A SAFE is an agreement between an investor and a company whereby the investor agrees to give the company funds for the right to either:
- Automatically acquire equity securities of a company at a later date in connection with a future equity financing of that company, or
- Be paid out in cash if a liquidity event occurs prior to the occurrence of any equity financing.
SAFEs generally do not have any expiration dates and will terminate upon the conversion of the SAFE into equity shares of the company or, if paid out in cash, in connection with a liquidity event.
As discussed further below, SAFEs will typically have a pre-determined formula for determining the SAFE's conversion price. This is based on either a valuation cap or the price payable by the investors in the event of a future equity financing, plus a discount, or some combination of the above.
While the SAFE is not technically equity and SAFE holders will not be entitled to the standard statutory protections of a shareholder, SAFEs will often contain contractual provisions that treat the SAFE similarly to preferred shares.
Mechanisms for determining conversion price of a SAFE
It is fair to say that the conversion price of a SAFE is the single most important term of any SAFE. A primary benefit to raising money with SAFEs is that your company may not need to determine its valuation and share price when accepting money from investors. The conversion price SAFE holders receive can be calculated and determined at the time of the next equity financing based, in part, on the price paid by the investors during the next equity financing.
There are several different terms that impact the calculation of the conversion price of a SAFE. The three main components are:
- Whether the SAFE has a valuation cap or not;
- If there is a valuation cap, whether it is a pre-money or post-money valuation cap; and
- Whether the price, with or without a valuation cap, is discounted or not.
Capped and no cap
A valuation cap in a SAFE functions to provide a ceiling on the SAFE's conversion price and, as a result, can increase the number of shares that are issuable under the SAFE when the SAFE converts. With an upward limit on the conversion price, this provides investors with greater protection for preserving the percentage ownership of the company the investor can expect to have following conversion of the SAFE and can provide the investor with a discount in some circumstances.
As an example, if the company has a valuation that is greater than the valuation cap at the time of the next equity financing, the SAFE automatically converts at the valuation cap, rather than the actual valuation of the company. This results in a lower SAFE conversion price, and more shares, than the price payable by the investors in the next equity financing.
In contrast, if the company has a valuation that is less than the valuation cap at the time of the next equity financing, the SAFE will generally convert into shares at the current valuation resulting in SAFE conversion price equal to what is payable by the investors in the next equity financing. Additionally, in either case, as discussed below, the SAFE holder may be entitled to a discount.
Pre and post money valuation
Valuation caps can be based on a pre-money or post-money valuation, which significantly impacts both how a founder's shares and the SAFE holder's conversion shares are diluted.
In pre-money SAFEs, the valuation cap is divided by the capitalization of the company, without including the shares issuable upon the conversion of the existing SAFEs. Accordingly, upon conversion, the ownership of all other SAFE holders and founders becomes diluted based on the number of SAFEs converting. As a result, the percentage ownership of each SAFE holder and the founder is unknown until the completion of the conversion of the SAFEs. Pre-money valuation is often considered more attractive for founders, as it results in less dilution of their shares compared to post-money valuation, since all parties are being diluted.
On the other hand, in post-money valuation SAFEs the valuation cap is divided by the capitalization of the company including the conversion of the issued and outstanding SAFEs. This gives investors more certainty by providing a fixed percentage of the company a SAFE will convert to prior to the triggering event, regardless of how many other SAFEs are issued in the meantime. Post-money valuation SAFEs provide the advantage of certainty for investors but run the risk of heavily diluting a founder's shares, as they remain the only party whose shares are diluted when new SAFEs are issued. This is particularly the case if the company oversells the SAFE offering without adjusting the post-money valuation cap.
Discounted price
While a valuation cap can function as a form of discounted price, SAFEs that do not have valuation caps will typically provide SAFE holders a discounted conversion price (for example, 10% to 30% discount) to the price that is paid by investors in any equity financing.
In some cases, a SAFE holder will be given the right, upon conversion, to receive the greater number of shares that result from using the valuation cap or the discounted rate.
Where the same class of shares is being issued for different prices, companies may wish to consult with their tax advisors on whether issuing the shares in different series is appropriate in the circumstances.
Most favoured nation provision
In the context where a company is issuing a number of SAFEs to different investors, with different terms, over a period of time, SAFEs can contain a most favored nation provision. Such a provision guarantees the SAFE holder that should the company issue a SAFE to a different investor with better terms, the terms of the SAFE will automatically be adjusted. This way, the SAFE holder receives the best terms that have been offered.
Subscription agreement considerations
While it is possible to have an investor enter into a subscription agreement in connection with the entering into of a SAFE, this is generally not the market standard. Instead, SAFEs will either automatically convert into equity securities without a subscription agreement or the investor agrees to enter into the same subscription agreement or form of subscription agreement as the investors coming on the equity financing. For companies, if a subscription agreement is not being used, when entering into the SAFE, it is important to ensure that you are obtaining the requisite information and certifications from investors with respect to their exemption under applicable Canadian securities laws.
Shareholders' agreement considerations
For companies that have or intend to have a shareholders' agreement in place when they undertake an equity financing in the future, careful consideration should be given to having the SAFE holders agree, in advance, to entering into the shareholders' agreement or the shareholder agreement that exists at the time of the conversion of the SAFE. For this purpose, SAFEs will often include a form of joinder agreement binding holders to the shareholders' agreement that is attached to the certificate.
Class of shares and future equity financings
As the future capitalization of a company is often unknown at the time that a SAFE offering is completed, is often unclear which class of shares will be issued at the time of a future financing. To demystify this unknown for investors, SAFEs will generally either convert into shares with the most favourable rights and/or the same class of shares that are subscribed for by third-party investors coming in at a future equity financing.
An additional protection that can be added is a requirement that the company raise a minimum amount of proceeds pursuant to the future equity financing in order to trigger the automatic conversion of the SAFE. This ensures that the company has been able to sell the shares to a sufficient number of third parties to validate the valuation of the company.
Canadian securities law considerations
There are forms of SAFEs that are available on ycombinator. While these forms are a good starting point, the forms do not contain sufficient details with respect to the necessary exemptions under Canadian securities laws and have references to U.S. law that are not necessarily applicable to Canadian companies (unless they are distributing securities in the U.S.).
We recommend that you consult your own legal advisors when preparing a SAFE to ensure that you are in compliance with Canadian securities laws.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
