Reviewing the New SAFE Investment Instrument

Recently made available by Y Combinator, the SAFE investment instrument is intended to improve on the highly popular convertible note used by startups during the seed stage or as a short-term bridge between equity rounds.  SAFE stands for “simple agreement for future equity”.  The purpose of this blog post is to generally review the elements that make up a SAFE investment and compare them to a convertible note.  For those not already highly familiar with convertible notes, see my blog post title “Convertible Note Basics” for a primer.

Before jumping into the review and comparison, I’ll say that I generally like SAFE and would not have a problem investing using it, either as an investor or recommending it to a startup I advise.  I can’t yet say that I prefer it over a convertible note.  Instead, I see both as viable investment instruments for seed stage investing, each with their own pros and cons.  I’m not quite sure I like the name because all seed stage investing is highly risky but hopefully accredited investors already know that.  Coming up with an acronym for SIMPLE might have been more appropriate but I’m at least happy to see another viable seed stage investment instrument in the market.

Summary

SAFE is a short, 5-page investment document that is intended to be simple to understand and convenient to administer.  It’s not a debt instrument but rather investments via SAFE show up on the company’s capitalization table (cap table) like other convertible securities (ie – warrants, options).  So in this regard, SAFE provides investors the opportunity to convert their investment to equity at a point in the future when an equity round is raised and preferred shares are issued.  SAFE has provisions for early exit (change of control) or dissolution of the company and it also has preferential provisions for investors such as discounts and valuation caps.  But one thing SAFE doesn’t have is a maturity date (remember, it’s not a debt instrument), so there is a possibility that it never converts to equity and there’s nothing in the terms that call for the investment to be repaid to the investor.

Comparing SAFE to a Convertible Note

Simplicity- Both are fairly simple to understand but since SAFE isn’t a debt instrument and since its creators took special care to keep it ultra simple, it literally fits on five pages.
(Advantage: SAFE)

Conversion to Equity- Both convert to equity when a future priced/equity round is closed.  However, convertible notes stipulate a minimum amount of money to be raised in a future equity round before being considered a “qualifying transaction” that triggers conversion.  SAFE investments convert with any amount raised in an equity round, which is definitely a simpler approach and something that should appeal to investors since they don’t have to worry if/when the company will raise enough money to be considered a “qualifying transaction”.
(Advantage: SAFE)

Discount- Both offer a discount to early investors, which is applied to the valuation used during the future equity round.
(No Advantage)

Valuation Cap- Both offer the investor the choice of the discounted valuation (using the stated discount) or a pre-negotiated valuation cap, whichever is more favorable at the time of conversion.  (See my related post titled “Justifying the Cap Amount in Your Convertible Note“)
(No Advantage)

Early Exit- Both offer similar payout mechanisms if a change of control event (ie – acquisition) happens before a natural conversion to equity.  Note that the SAFE documents are written to give the investor a choice of a 1X payout or conversion to equity at the cap amount and then participation in the acquisition along with other equity holders.  Since many convertible notes offer a 2X payout option, this is one thing I expect to see investors negotiate into the SAFE document.
(No Advantage)

Interest Rate- Convertible notes have them since they are debt instruments but SAFEs don’t.  I’m not sure seed stage investors care much about the interest they accrue on convertible notes, but the truth is a note that carries an 8% interest for 18 months before converting can accrue a non-trivial amount of interest that also converts to equity along with the invested principal.
(Advantage: Convertible Note)

Maturity Date (Term) – Convertible notes have them since they are debt instruments but SAFEs don’t.  To evaluate this difference, you have to think about two scenarios.  In a case where the company is doing well but just hasn’t needed to raise additional funding as soon as they thought, the company and the investors usually have two choices.  They can either agree to extend the maturity date on the convertible note rather than force a payoff of the note or some convertible notes have an option to convert to equity using the valuation cap amount as the pre-money valuation if the maturity date is reached.  In a case where the company is struggling and likely not going to survive, the convertible note investors can try to force a payoff of the note, but the final result probably isn’t going to be very exciting for either party.  Since the SAFE doesn’t have the concept of a maturity date or term, possibly the biggest risk is with companies that do so well that they never need to raise an equity round and the SAFE investments never convert naturally.  But a well-performing company like this isn’t just going to leave their seed stage investors hanging and surely will figure out a way to convert them to equity – it’s just not certain at all how fair the investors will feel the terms of conversion are because the company holds all the power in such a negotiation.
(Advantage: Convertible Note)

Company Business Structure- Often times, companies raising seed stage money are still in LLC formation (rather than a C-corporation).  Since a convertible note is a debt instrument, it is usually fine for an LLC to use.  However, SAFE appears to require incorporation since the value of the SAFE investment is reflected on the cap table like warrants or stock options.  I’m guessing this could affect 50-75% of startups that are still less than $500K in revenue and haven’t otherwise had a reason to convert to a C-corp.
(Advantage: Convertible Note)

SAFE versus C-Note

I can’t suggest to simply add up the scoring from my assessment above to determine a “winner” because each company seeking seed-round investment is so different and with many factors playing an influence.  So instead, entrepreneurs should assess their current situation, expected future path, and investors’ interests and concerns before deciding which instrument is best to use.  Having said that, above is a quick summary graphic based on my assessment.

There are a couple of other miscellaneous points worth mentioning about SAFE:

  • There are questions as to the effect SAFEs will have on the Fair Market Value of the company (used to set the current share price).  Should raising money via SAFE trigger a 409A valuation or not?
  • Interestingly, the sale of Common stock to raise money doesn’t naturally trigger conversion for SAFE investors.  This is the same with most convertible notes but they have maturity dates that force some sort of action eventually.
  • If the startup does well and never needs to raise money via the sale of Preferred shares, they could start issuing dividend payments to Common shareholders and SAFE investors wouldn’t be entitled to participate in those payments.
  • Following a conversion to equity, certain rights granted to SAFE investors are based on their original investment amount.  This is done via a separate series of preferred stock, commonly called “shadow” or “sub-series” preferred.  The rights affected include the liquidation preference and dividend rate.  This is necessary due to the discount or if the valuation cap comes into play, both of which give the SAFE investor a preferential price per share.  Seems fair and isn’t something most convertible notes take into account.

Check out my other blog posts on Fundraising here.

Categories: Fundraising | 8 Comments

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8 thoughts on “Reviewing the New SAFE Investment Instrument

  1. Pingback: Convertible Note Basics | Shockwave Innovations

  2. Thanks Gordon for your analysis.
    The intent of a convertible note is not to be repaid but to convert to equity. But a convertible noteholder still has the (illusory) comfort that he must be reckoned with if the Company has not raised a “qualifying” preferred round and cannot pay the loan on the maturity date. The SAFE is a form of nonvoting convertible equity. A SAFEholder has no rights until a preferred round or exit. I am not sure that investors outside the Y Combinator world will be comfortable with that.
    One technical note: the SAFE document should more clearly address the possibility of the Company distributing dividends to its common stockholders prior to an Equity Financing or Liquidity Event. (Say the Company never needs additional funds, or it raises funds via debt or issuing common stock.) The SAFEholders will never participate in those dividends. (Arguably, the second sentence of Section 1(c) (Dissoluiton Event) could be interpreted to address this possibility — but a dividend is not a Dissolution Event. And it doesn’t reach the right result: the dividend should trigger a right to convert or get repaid.)

    • Thanks for the comments Saul. It will be interesting to see how investors influence changes to the standard SAFE docs, just like what happened with C-notes over time. The lack of a time-based trigger is one I plan to keep an eye on. I wonder if there would be legal or accounting problems including a term that says if the SAFE goes unconverted for 24 months (or whatever period) it automatically converts using the cap amount as the valuation. Also thanks for your mention of the exposure with dividend payouts not triggering a conversion and potentially leaving the SAFE investor on the sidelines while payouts are occurring for others.

  3. Pingback: How Much Should You Raise? | Shockwave Innovations

  4. Dave M

    Hello,

    Would it be possible for an LLC to use a SAFE document if it plans on converting to an LLC at the time of the first round of financing?

    • Great question, and I’m only fairly certain about my answer. SAFE appears to require incorporation (S-corp, C-corp) since the value of the SAFE investment is reflected on the capitalization table like warrants or stock options. But if this is important, you should check with your attorney to confirm. And if you do, please come back and add another comment so we can all have the benefit of the answer.

      • According to my attorney, a SAFE-like document cant be used, but it needs to be modified slightly. We are also warranting that we will Inc. at the time of the initial round.

  5. Hi Gordon, great post. For purposes of adding to the discussion, I think that an LLC can probably use a SAFE. As the comment above suggests, the trick is to make sure that the equity capital structure outlined in the LLC agreement matches the equity contemplated in the SAFE Agreement.

    We routinely draft equity compensation plans for LLC clients and do convertible note and warrants for LLCs (in addition for options). So, a properly drafted LLC Operating Agreement can accommodate convertible equity or the SAFE concept. There are some unique features to the taxation of LLCs and the general operation of LLCs can affect these things.

    Generally speaking, start up companies can maximize their ability to take advantage of more informal management structures and loss pass-through by using the LLC form prior to taking on an institutional round. At the point that the investor takes institutional VC funds, they will likely be requested to do a merger into a new Delaware C-Corporation or use a statutory conversion into that entity. Therefore, for any company using the LLC strategy prior to the institutional round, it is important that the company adopt equity and convertible equity structures that are easily changed into corresponding corporate capital structures prior to or upon the closing of that institutional round.

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