What Is A SAFE Agreement?
Startups employ SAFE agreements, also known as simple agreements for future equity, and SAFE notes, which are legal instruments that are comparable to warrants, to secure pre-seed funding capital. They serve as a substitute for convertible notes. The startup’s and investor’s relationship with regard to equity rights for triggering liquidity events is established by the terms and conditions of SAFE agreements.
How do the SAFE Agreements function?
It’s difficult to assess the worth of a startup in its early stages. This issue is addressed via SAFE agreements. They allow you to postpone valuation to a later date while simultaneously investing or raising seed capital for the business.
As the company grows, it will very certainly raise more capital and hence increase in value. This is the outcome that investors seek. When new investors perform pricing rounds in the future, the SAFE agreement turns to company shares.
Example of How Safe Agreements Operates.
Assume you invest $25,000 through a SAFE agreement. Because assigning a price to early-stage enterprises is nearly useless, the startup will use its SAFE agreement to recruit additional investors and delay the valuation to a later date. The investors are merely purchasing the right to stock in the future when the firm has traction and performance data that would allow an institutional investor to appropriately value the startup. At this stage, your $25,000 would be converted into equity in relation to the valuation of the pricing round. Early investors often benefit from taking a risk, such as discounts and valuation caps.
Important Elements in a SAFE Agreement
SAFE agreements are powerful investing tools for Venture capitalists. However, there are important terms in SAFE Agreements that you must understand. The five terms we’ll consider in this blog include discounts, valuation caps, pre-money or post-money, pro-rata rights, and the most favoured nation’s provision.
SAFE contracts may involve a discount. If the SAFE investor’s money converts in future fundraising rounds and the valuation is at or below the valuation cap, the discount is applied. A 20% discount rate, for example, means that an investor’s money would buy shares at a $8 million valuation if the pricing round was $10 million (20% discount).
Another popular phrase in SAFE agreements is valuation caps, which investors can use to acquire a more advantageous price per share in the future by setting a maximum convertible price. They compensate investors for taking on more risk.
Assume a startup is raising financing at a $10 million valuation and the SAFE investor has a valuation cap of $5 million. In that situation, SAFE investors’ shares convert at the valuation cap ($5 million), despite the firm being valued at $10 million. SAFE investors are usually pleased when the valuation cap comes into action.
Pre-Money or Post-Money
Pre-money and post-money valuation metrics assist investors and founders in understanding how much a firm is worth. It’s one of the most important clauses of a SAFE agreement. The term “pre-money” refers to the valuation prior to the arrival of new investor capital. The valuation is post-money if it includes the capital raised in that round.
Pro-rata rights allow investors to add extra funds in order to keep ownership percentage rights following equity fundraising rounds. The investor will pay the new price rather than the old amount. These rights are a wonderful method to keep long-term investors motivated.
Most-favored Nations Provision
Most-favored-nation provisions (MFNs), often known as non-discrimination clauses, oblige companies to treat all investors equally. For example, if future investors receive better terms on convertible securities, past investors will receive the same terms.
For example, if you invest in a firm at a 20% discount and a $3 million valuation cap, and a future investor obtains a 30% discount, you will also receive the 30% discount.
SAFE Agreement vs. Convertible Note
SAFE agreements are distinct from convertible notes. The former is a contractual arrangement that could convert into equity in a future funding round, whereas the latter is short-term debt that converts into equity. However, they are similar in terms of simplicity and flexibility, which are appealing to both investors and companies.
Here’s a closer look at the differences between SAFE agreements and convertible notes below:
Interest Rates and Maturity
SAFE agreements are preferred over convertible notes in some circles since they are not debt. As a result, investors do not need to be concerned about interest rates or maturity dates. Convertible notes, on the other hand, include both of these elements. Many companies would wish to avoid having debt on their balance sheets.
SAFEs can also be used as a stand-alone instrument that functions in conjunction with additional SAFE agreements purchased by new investors at different periods and quantities in the future. Convertible notes can be arranged as a single note or as part of a series.
SAFE agreements differ from convertible notes in terms of risk and tolerance. Investors may be unfamiliar with convertible notes or uncertain about the tax consequences of a SAFE arrangement. Convertible notes are the gold standard for simple, flexible investment products.
Because SAFE agreements are relatively new, they can act as a standardized framework. In short, they are increasingly comparable from investment to investment. Convertible notes, on the other hand, exist in a variety of forms, increasing investment flexibility.
So which one is Better? SAFEs or Convertible Notes
The sort of instrument you select is determined by the startup and the investor. Understanding the advantages and disadvantages of each will help you understand why they are employed and, perhaps, which one will work best for you. Venture capital lawyers can also be a source of information and expertise for both entrepreneurs and investors.
Is a SAFE Agreement Debt or Equity?
SAFE agreements are neither debt nor equity. Instead, they are contractual rights to future equity. These rights are given in exchange for early capital contributions to the firm. SAFE agreements enable investors to convert their investments into shares at a later date during a pricing round.
It’s also worth mentioning that SAFE agreements are sophisticated, high-risk securities that may never be converted into stock. They do not accrue interest, and businesses are not compelled to repay investors if they fail.
How Are SAFEs Accounted For?
In general, companies should treat SAFEs as long-term liabilities. SAFE agreement accounting works in this way because it requires startups to produce an unknown number of future shares at an unknown price. As a result, more definitive data cannot be established, nor can performance indicators be realized.
The Securities and Exchange Commission (SEC) also urges investors to exercise caution while employing SAFE agreements. While they can be easily constructed, keep in mind that they are not all made equal. Furthermore, triggering liquidity events may never occur.
Investors’ rights are often greater than ordinary stock shareholders’ rights when a SAFE agreement proceeds well. As a result, SAFEs provide preferential privileges that are particularly appealing to experienced investors.
Get Help with SAFE Agreements
Due to the complexities associated with SAFE agreements, you must draft the terms and conditions accordingly. Once you sign the agreement, then a complete and binding deal is in effect. Securities lawyers possess a strong command of finance law and a wide range of experiences with startups. Ensure you seek their legal counsel before offering or accepting a SAFE agreement.
Safe notes are one of the easiest ways to raise pre-seed funding and transform it into Venture Capital Funding as time progresses. After reading this blog you will have a clear picture of the SAFE’s Agreement features, function, the importance of SAFE’s agreements, the difference between SAFEs or Convertible Notes, and how Safe’s are accounted for. One such firm in India that helps businesses with its bookkeeping and other financial services is Starters’ CFO.
You can contact an expert financial service provider like Starters’ CFO to ensure the best financing for your Business as well as eliminate doubts by exploring the best possible options and possibilities