By Fernando Berrocal
As an early-stage startup, weighing your funding choices might be overwhelming, but there is one approach that stands out for its simplicity: the SAFE agreement.
- What’s a SAFE
SAFE is an acronym for Simple Agreement for Future Equity. It's a convertible instrument, which is an investment that converts to equity at a certain period. That "specified time" in SAFEs is generally your startup's next pricing round.
What's the distinction between a SAFE and a priced round? A priced round is an investment in your startup based on a negotiated valuation. You offer investors shares of equity in exchange for the money they give you during a pricing round, such as a Series A round.
When using SAFEs to raise funds, however, you don't offer investors anything right immediately; instead, you promise them future equity in return for their current investment. SAFEs, on the other hand, are typically looser and more flexible than expensive rounds.
What’s the distinction between a SAFE note and a convertible note? A convertible note, like a SAFE, is a type of convertible instrument that changes into equity at a specific period. A note, unlike a SAFE, is considered debt, which implies it has an interest rate and an expiration (or maturity) date. A SAFE has no interest or maturity date, but it usually has a value cap and/or a conversion discount to protect investors.
Convertible notes and SAFEs both convert to equity at different periods. While SAFEs convert to equity at the next priced round (regardless of how much money your startup gets), convertible notes generally convert to equity only when a specific amount of cash is raised in a priced round, such as $1 million.
What type of company can issue a SAFE? If you want to use SAFEs for fundraising, your startup must be designated as a C-Corp, which means you have a defined ownership structure and must pay corporate income taxes on profits and losses. LLCs may be able to raise SAFEs in some circumstances, but the procedure is more difficult. In general, it's simpler to obtain money as a C - Corp than as an LLC, because LLCs are seen as generally riskier by investors.
- The key SAFE terms you Need to Know
It's important to understand the following ideas to raise money with SAFEs:
- Valuation Price: A valuation cap is a maximum value at which an investor's money can be converted into equity to determine the price per share. SAFEs have value restrictions in place to encourage early investors and reward them for taking a chance on your startup.
- Discount price (or Conversion Discount): When a SAFE converts to equity, the discount price, also known as a conversion discount, provides investors a discount on the price per share. In a pricing round, for example, if Series A investors pay $1 per share, a SAFE holder with a conversion discount will be able to acquire their shares for less than $1 per share.
- Most Favored Nation Clause: Investors are protected by the Most Favored Nation (MFN) clause, which occurs in the legal paperwork outlining the conditions of a SAFE.
If you issue further convertible securities to subsequent investors with better conditions (such as a lower value cap), the MFN clause generally specifies that such terms will immediately apply to your initial investor's SAFE as well.
- Qualifying Round: A qualifying round, also called a qualifying event or transaction, is the pricing round at which a SAFE will convert into equity. When it comes to fundraising using SAFEs, every priced round is usually a qualifying round.
- Exit Event: A change of control inside your startups, such as an IPO or “Liquidity Event”, is referred to as an exit event. Investors holding SAFEs will get cash profits proportional to their investment conditions if you have an exit event before your SAFEs convert to equity.
- Four important factors to consider before you raise a SAFE
Take some time to think about your company's goals and equity distribution strategy before you start fundraising with SAFEs. Answering the questions below will help you determine if SAFEs are a viable fundraising option for your startup.
- What percentage of your company's stock do you intend to give up? Your shares will be diluted when you bring in additional investors and raise more money through SAFEs. Since you're not technically giving away shares of stock when you issue a SAFE, determining how much equity you're losing might be difficult.
- In your next pricing round, how much money do you want to raise? You won't be able to forecast precisely how much money you'll raise during your next pricing round, but you should have a good idea of what you want to raise.
If you use SAFEs to raise too much money, you risk diluting your Series A investors when the SAFEs convert to equity. However, setting aside a portion of your equity for your next pricing round can assist keep prospective investors interested and motivated.
- What goals will you achieve with the funds? You want to raise enough money in your seed round to achieve the precise milestones that will boost your startup's value and prepare you for success in your Series A round. Achieving an internal growth objective, introducing a product within a certain timeframe, meeting a certain fundraising target, or recruiting a specific investor are all examples of milestones.
- What method will you use to keep track of your SAFE investments? Many early-stage entrepreneurs make the error of failing to properly document their exceptional SAFEs. You may have a different valuation cap or conversion discount for each SAFE you issue, and if you don't keep track of these details, you may end up diluting your ownership more than you intended.
- Pros and Cons of Fundraising with SAFEs
As with any fundraising strategy, there are advantages and disadvantages to using SAFEs.
- Benefits of using a SAFE to raise funds:
- SAFEs may be both quicker and less expensive than a priced round. With a SAFE, you can prepare contracts faster and pay less money on legal costs since there are fewer terms to discuss and negotiate.
- Investors are interested in them. Because they are shielded by the valuation cap or conversion discount, early investors may be more ready to take a chance on your startup.
- They allow you to take your time to achieve specific goals. SAFEs allow you to fundraise with greater flexibility if you need cash immediately but don't want to conduct a formalized valuation just yet.
- There are no interest rates for them. With a SAFE, you don't have to worry about paying off debt as a founder.
- Drawbacks of using a SAFE to raise funds:
- This could result in an overabundance of dilution. You might end up overdiluting your shares or the shares designated for your Series A investors if you're not careful about where you set your value cap.
- You may have a more difficult time attracting investors. You may have to look harder for investors ready to invest in your startup early if you don't have a visible lead investor to drive up interest (as in a pricing round).
- Getting started with SAFEs
SAFEs are a simple and effective method to raise money for your startup during its initial stage. They're simple to use, inexpensive, and quick to print; yet, if you're not careful, they can lead to over-dilution issues. Take some time to evaluate your aims and fundraising targets if you want to raise money with a SAFE.
Are you looking for others ways to raise money for your startup and bring it to the next level? Apply to MassLight’s next batch. MassLight supplies capital and a dedicated tech team. We take equity in return. Have questions? Refer to our FAQ page.