SAFE: what is it and what to pay attention to
Content of the article
Should you accept investments via SAFE?
The Simple Agreement for Future Equity (SAFE) was created in the USA in 2013 by the venture fund Y Combinator. Translated, it means a “simple agreement for future equity.” This type of agreement has become a great alternative to other investment types due to its straightforward implementation and is arguably the most popular in the IT and startup sectors.
When legally supporting investment attractions, we regularly work with SAFE. In this article, we’ll share the specifics of SAFE and what terms to pay attention to.
Important terms
To better understand the processes involved in attracting investments through SAFE, it’s valuable to consider different options for each party of the agreement. Investors should accurately assess the amount of investment, the order of their conversion into company shares, the influence on founders, and options for receiving dividends. Owners should correctly evaluate their startup and its future growth to allocate an appropriate share for the investor. Among the essential tools in SAFE, attention should be given to the following:
Discount: A startup can additionally motivate an investor by providing a discount on shares, which can be applied after valuation. For example, a 20% discount rate means the investor can buy $10 worth of shares for $8.
Valuation Cap: At the time of a SAFE agreement, it is unknown how successfully the project will develop and how much it will grow by the time of valuation. This growth could be relatively modest or astronomical. To protect against such imbalances, a valuation cap is set. If the SAFE states that the valuation cap is at $10 million, then at a project valuation of $15-20 million, the investor receives a share as if the project was valued at $10 million.
Since valuation sizes can vary depending on approaches, it’s recommended to determine the valuation method in advance and what happens if the parties do not agree on the valuation.
Pre-Money or Post-Money relates to valuation measurements that help investors and founders understand how much the company is worth. Pre-money means the valuation is done before the money from new investors is considered. Post-money implies that the valuation includes the capital raised in this round.
Non-Discrimination Provision: Requires startups to provide the same privileges to all investors. For example, if shares are issued to future investors on better terms, previous investors also get the same terms.
Pro-rata Rights allow investors to add more funds to maintain their percentage ownership following equity financing rounds. For this, the investor must pay the new price compared to the initial cost. These rights are one way to keep investors motivated to continue with the project’s development.
Implementation of SAFE: Practical aspects, such as signing, format, and timelines for transactions, reporting, involvement in activities, and managerial decisions. Often, investors under SAFE only have advisory voices and recommendations and do not significantly influence the chosen development path.
The above conditions are not exhaustive. The flexibility of the SAFE agreement allows for the wishes of the parties and the specifics of the project to be considered, as well as the choice of law for the agreement under a specific country’s jurisdiction.
Action algorithm
There are various SAFE conditions that differ from each other. However, a typical action algorithm will likely be as follows:
- Preliminary assessment and review of the project, as well as agreement on investment terms.
- Investing in exchange for a commitment to allocate a share to the investor after valuation. Variations such as fixed percentages, immediate inclusion in the ownership structure, etc., are possible.
The investor provides the investment to the startup. Payment format and timelines are agreed upon in the contract, but this usually occurs in the company’s account. The investment itself can be not only in monetary form but also in manufacturing capabilities, being a part of the team, covering expenses, participating in development, etc.
In a classic SAFE – the investor subsequently receives shares according to the next valuation of the startup, but the parties can immediately agree on fixed percentages and the possibility of increasing their number.
As this is a startup, the stages may generally not occur, and the project may be closed or significantly changed. Thus, investing in startups, including at early stages (pre-seed), is quite risky. The parties should find a win-win solution where the startup receives the necessary amount of investment for development, and the investor can cover their own risks.
Despite the defined conditions for converting investments into shares, there may be scenarios where such circumstances do not occur (closure of the project), or there simply will be no next round of investment. For example, if the company is already earning enough money that it no longer needs to attract capital or private investments. These circumstances are also subject to regulation by SAFE.
Alternative ways of attracting investments
The SAFE agreement is just one way of attracting investments. However, alternatives can always be considered: buyout of corporate rights and a limited circle of owners; mergers or amalgamations with other startups for resource distribution, cost sharing, and joint progress; crowdfunding; grant programs that can be targeted both at startups in general and specific industries of activity.
Conclusion
Approach any investment agreements consciously and by calculating future steps. When it comes to SAFE, this may include:
- Defining zones of responsibility for the parties (whether the investor only provides investment or also participates in development, success metrics, decision-making processes for development strategies, etc.);
- The process of acquiring shares and conditions (discounts, valuation, terms, etc.). A common mistake for startups at early stages is to offer fixed percentages to a large number of investors, which can later lead to a loss of ownership rights or inability to make managerial decisions;
- The process of conducting transactions, terms, and subsequent actions of the parties both in the successful development of the project and when additional funding is needed.
Do not forget and prepare in advance for the project’s due diligence and building a corporate structure:
- This includes choosing the optimal jurisdiction for attracting investments and developing the project, as well as creating a corporate structure. Typically, a startup might have a group of companies: a holding company for attracting investments and holding property rights (intellectual property, movable and immovable property), for operational activities and relations with third parties, etc.;
- Intellectual property rights are often the main asset of most startups, so it is crucial to protect the brand and technologies in key markets in advance;
- Relations with the team, partners, and contractors should involve signing appropriate agreements like NDAs and NCAs;
- Of course, public documents and data protection such as Terms of Use, Privacy Notice must be handled properly. Otherwise, tech startups or their mobile applications may be blocked on marketplaces due to violations of standards or requirements.
Posted by CASES
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