When looking at startup investments, you're likely to come across offerings issuing a SAFE, or a Simple Agreement for Future Equity. Keep reading to find out this type of instrument is and how it works.
Getting in early on a startup that develops into an industry titan is pretty much the ultimate object of every investor’s desire. It makes a lot of sense when you think about the fact that just one investment in the right startup can build generational wealth. However, one of the reasons startup investing yields high rewards is that the profit potential comes with a highly elevated risk factor.
By definition, a startup company is new, has no objective market value and is much more likely to fail than succeed. That’s why it’s usually very difficult for startups to get seed money through traditional lending. Because of this, both startups and investors need creative solutions to finance the company’s early development. One of these creative solutions is the simple agreement for future equity (SAFE).
What is a SAFE?
A SAFE is a creative financing arrangement that allows investors to provide startup funding for the company. However, instead of a loan that promises the noteholder they will be paid back the loan principal plus interest, SAFEs usually entitle the noteholder to convert their funding into equity shares (or the right to buy them) in the startup at a preferred, discounted rate.
How Does a SAFE Work?
As noted in the section above, SAFEs entitle the holder to equity, or the opportunity to purchase equity at a steep discount, in a startup in exchange for putting seed money into the startup. In a perfect world, the startup will thrive and the startup investor’s contribution will translate into share value worth several hundred times more than the initial investment.
Although SAFEs are similar to convertible notes, they differ in several key respects. First of all, SAFEs are not loans. Because of this, SAFE notes are not listed as debt on the startup’s books. This distinction is important because if the startup goes public or gets its first valuations for investing, the startup’s value will be negatively affected by debt on its books.
A SAFE has no set expiration or maturity date, which offers both the holder and the startup an added element of flexibility. For example, if the startup is close to a second round of funding, but a maturity date on a convertible note is hanging over its head, new investors might be scared off. However, because SAFEs are not loans, no debt or payoff date exists. Yet the equity conversion aspect of SAFEs means the noteholder’s equity options are protected regardless.
Additionally, convertible notes usually have interest rates attached to them. Even though this interest is usually converted to additional shares, it’s still extra debt for the startup, and startups are always better off with less debt on their books.
Another important part of SAFEs is that they do not have a qualifying equity round amount. This means SAFE holders can exercise their share rights automatically when the startup receives additional funding. Convertible notes by contrast, often contain qualifying equity clauses.
SAFEs also do not have deferred valuation clauses. Deferred valuation clauses allow the issuer of a SAFE to defer the holder’s right to purchase shares until a later date if the startup doesn’t reach a certain valuatio, a clause often found in convertible notes. Although the clause doesn’t necessarily hurt the noteholder, it could prevent them from exercising their share rights and liquidating or transferring them if the need should arise.
At the end of the day, SAFEs essentially function as a shadow stock purchase. In exchange for early financing of the startup, the SAFE holders basically become stockholders in the startups they buy notes from. When, where and if the SAFE holder exercises their stock options under the SAFE note is laid out clearly and concisely in the terms of the SAFE.
Why Would Investors Choose a SAFE?
Although SAFEs and convertible notes are both creative ways for investors to provide startup funding, SAFEs offer noteholders some significant advantages over convertible notes. First among those advantages is simplicity.
Convertible notes can be complex and contain a number of different trigger clauses that must be hit before the noteholder becomes an equity owner in the startup. Because of this, the simple act of negotiating a convertible note between the issuer and the noteholder can require a tremendous amount of negotiation between the parties.
Usually, negotiation leads to lengthy legal reviews of each convertible note proposal. These legal fees are basically dead money for both the convertible note issuer and the noteholder. It’s money that must be paid, but money that neither of them can really recoup.
By contrast, SAFEs are more straightforward with no maturity dates, discount rates, interest rates or discounts on the valuation cap because SAFE notes offer simple equity in exchange for funding. So, SAFE holders can be more likely than convertible note holders to see their money turned into equity, and they get a simple, easy-to-understand document that describes exactly how that conversion takes place.
Like convertible notes, SAFEs come with no guarantees and lots of risk. As SEC guidance points out “despite the identified triggers for conversion of the SAFE, there may be scenarios where the triggers aren’t activated and the SAFE is not converted, leaving you with nothing. For example, if a company in which you invested makes enough money that it never again needs to raise capital, and it’s not acquired by another company, then the conversion of the SAFE may never be triggered.”
SAFEs typically contain low valuation caps that allow them to convert their note into equity at a lower price than future shareholders. For these reasons, many startup investors prefer SAFEs to convertible notes.
Benzinga’s Best Startup Offerings
A few successful startup investments can turbocharge your investment portfolio and create almost unimaginable wealth in relation to the original investment amount. While startups may be a little too risky to build your entire portfolio around them, they are great ways to diversify while adding potential upside. If you’ve been looking for some startups to invest in, take a look at Benzinga’s best startup offerings below.
Should You Buy SAFEs?
Startup investing is still a wonderful way to accomplish the two missions of wealth building and diversification at the same time. One of the best ways to do startup investing is to buy SAFEs. They are relatively straightforward investment vehicles that offer you a great opportunity to get equity in exciting startups at a much lower price than you’ll pay after an initial public offering.
So, you should take a look at making SAFEs a part of your investment portfolio. As is the case with all investments, you must consider your goals and risk tolerance before buying a SAFE. But if you’ve done your due diligence and like what you see, the right SAFE could pay off with huge dividends down the road. If you have any questions about a SAFE or startup funding in the meantime, Benzinga will be there as a resource to provide valuable information.
What is seed financing and how does it work?
Imagine a startup company as an apple seed. It may grow into a profitable company, but it needs water. In the world of startup investing, seed financing is like water. Farmers provide water and positive conditions for seeds to grow into fruit-bearing trees whereas investors put money into a startup in the hopes that it will grow into a profit-generating business. The money investors provide for startups is known as “seed financing.”
If the farmer’s seed becomes a fruit-bearing tree, the farmer profits from selling the fruit. By the same token, investors who provide seed financing for startups usually get an equity share in the startup if it becomes profitable. The amount of equity is usually predetermined by a convertible note or a SAFE note which is negotiated between the startup and investor.
What does SAFE stand for?
In investments, SAFE stands for Simple Agreement for Future Equity.
Are SAFEs equity or debt?
SAFEs are considered equity. They are placeholders for the company’s next equity financing.
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