What Is A SAFE Agreement?
Startups utilize SAFE agreements, also known as simple agreements for future equity, and SAFE notes, legal instruments 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 future fundraising rounds value the company at or below the valuation cap, the discount applies to the SAFE investor’s money. 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 this situation, the firm’s valuation stands at $10 million, and SAFE investors’ shares convert at the valuation cap of $5 million, a development that typically pleases SAFE investors.
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 function as a stand-alone instrument that works in conjunction with additional SAFE agreements that new investors purchase at different periods and quantities in the future. Convertible notes can be structured 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.
SAFE agreements act as a standardized framework because they are increasingly comparable from investment to investment, while convertible notes, on the other hand, offer increased investment flexibility and exist in a variety of forms.
So which one is Better? SAFEs or Convertible Notes
The startup and the investor determine the type of instrument selected. Understanding the advantages and disadvantages of each will help you comprehend why they use them and, possibly, which one will suit you best. 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.
SAFE agreements, sophisticated and high-risk securities, may never convert into stock.
Businesses are not obligated to repay investors if they fail, and they do not accrue interest. 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.
Hence, we cannot establish more definitive data or realize performance indicators. The Securities and Exchange Commission (SEC) also urges investors to exercise caution while employing SAFE agreements.
Keep in mind that while you can easily construct them, not all are made equal. Furthermore, triggering liquidity events may never occur.
Experienced investors find SAFEs particularly appealing because they offer preferential privileges that often surpass the rights of ordinary stock shareholders when the agreement proceeds well.
Get Help with SAFE Agreements
To properly address the complexities associated with SAFE agreements, it’s crucial to draft the terms and conditions accordingly. Signing the agreement initiates a fully binding deal. Securities lawyers, leveraging their robust grasp of finance law and extensive startup expertise, can offer crucial legal guidance. Ensure you seek their advice before extending 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 gain a clear understanding of the features, function, importance, and differences between SAFE (Simple Agreement for Future Equity) agreements and Convertible Notes. Additionally, you will learn how to account for SAFE agreements. One such firm in India that helps businesses with its bookkeeping and other financial services is Starters’ CFO.
Contact an expert financial service provider like Starters’ CFO to ensure the best financing for your business and eliminate doubts by exploring the best possible options and possibilities.