knowledge | 12 November 2021 |
Simple Agreements for Future Equity - What are they and how can they be used?
Start-up businesses are increasingly focused on capital sources with more flexibility, less complexity and fewer transaction costs. As a result, Simple Agreements for Future Equity, also known as SAFE, a relatively new cost-effective mechanism for start-ups is currently gaining traction in Ireland. In this briefing, we seek to provide an analysis of the SAFE by providing the context necessary to understand its purpose and underlying mechanisms.
The SAFE emerged from US seed accelerator, Y Combinator in late 2013, and since then, it has been used with increasing regularity as the main instrument for early-stage fundraising. They are emerging as an alternative to more traditional forms of early-stage financing, such as convertible notes or preferred shares. Although Ireland took a while to embrace the SAFE, it has become increasingly popular in recent times.
What is a SAFE?
A SAFE is an agreement between an investor and a company that provides rights to the investor for future equity in the company similar to a warrant, except without determining a specific price per share (or a valuation) at the time of the initial investment. They negotiate things like valuation caps, discounts, maturity date and investment amounts.
Once the terms are agreed and the SAFE is signed, the investor sends the company the agreed funds. The company applies the funds according to any relevant terms and conditions. The investor does not obtain the equity until an event listed in the SAFE agreement triggers the conversion.
To summarise, a SAFE instrument is an investment contract between a start-up and an investor that gives the investor the future right to receive equity on certain triggering events which are usually:
- a future equity financing; or
- the sale of the company.
As mentioned, the intention of a SAFE is to be an alternative to convertible loan notes, however unlike a note they are not debt instruments. A SAFE is non-interest bearing and it often has no maturity. A similarity between a SAFE and a loan note is that they both can convert at discounts and/or at capped valuations.
What Founders Should Consider
SAFEs are used by start-ups specifically as a new way to raise money. There are many benefits to start-ups to use a SAFE instrument, namely their simplicity and flexibility. These factors contribute to a shorter negotiation process. As SAFEs are not debt instruments, founders do not have the threat of insolvency hanging over them should the company not have the cash when called, unlike convertible loan notes.
A SAFE instrument is similar to a convertible loan note in that it provides rights to a given investor for future equity in a company, but it is seen as a more founder-friendly alternative. In particular, given that there are no maturity dates or accruing interest, founders can focus on growing their business without the stress of debt or financing deadlines that convertible loan notes can cause.
Typically, there are only three material elements of the SAFE to negotiate with investors which are:
- the valuation cap;
- the discount; and
- a financing threshold at which the SAFE would covert.
This allows start-ups to avoid high legal costs in securing funding.
There are risks associated with SAFE instruments that start-ups should be aware of. For instance where a start-up partakes in a SAFE investment round prior to a priced equity round and the start-up’s value has increased substantially since, the investors under the SAFE will likely get a substantial discount on equity due to the valuation cap and the discount in the SAFE instrument. It is important for founders to carefully consider how much equity they are willing to give up. Some other common pitfalls for founders include:
- providing a discount that is too steep;
- negotiating additional terms;
- because the SAFE’s conversion into shares will depend on factors that are unknown at the time it is issued, there’s no absolute way to represent the SAFE in a cap table; and
- failing to receive proper legal and accounting advice.
What Investors Should Consider
Similarly to founders, investors also benefit from the simplicity of the nature of the SAFE investment and the standard form paperwork reduces negotiation time and allows investors to make decisions quickly. What makes a SAFE instrument attractive to prospective investors is that they receive the future shares, usually at a discounted price, when a priced round of investment or liquidity event occurs. They enable investors to convert their funding into shares at a point.
In terms of risks for investors, with SAFE investments there is the possibility that there is no future equity financing and the company never gets sold. In these circumstances the investors will typically not be able to trigger a conversion into equity. Also worth noting is that investors do not have any shareholders rights until the SAFE is converted to equity.
A SAFE is a simple tool for start-ups when raising early stage funding without incurring the higher costs and protracted negotiations associated with more traditional methods of financing.
SAFEs solve a number of issues that convertible loan notes have for start-up companies. While the SAFE may not be suitable for all financing situations, the terms are intended to be balanced, taking into account both the start-up’s and the investors’ interests.
There has been a notable increase in the use of SAFE agreements in the Irish fundraising community in recent times and largely this is a welcome development. However, exercising appropriate caution and obtaining proper legal and accounting advice is still important to ensure the start-up’s interests are properly protected.
How can we help?
McCann FitzGerald LLP is a premier Irish law firm. With over 650 staff located in our principal office in Dublin and our international offices in London, New York and Brussels, our specialists are ready to help your business thrive. Our Corporate practice combines with our Company Secretarial and Compliance Services group to offer your start-up enterprise the market-leading advice that you need to grow, from corporate advice on fundraising and governance, to day-to-day advice on compliance matters – leaving you free to focus on developing your business. Please contact any member of the McCann FitzGerald LLP Start Strong team for assistance.
This document has been prepared by McCann FitzGerald LLP for general guidance only and should not be regarded as a substitute for professional advice. Such advice should always be taken before acting on any of the matters discussed.