What is SAFE agreement and why is it important to understand for early-stage startups? In today's blog, we uncover the concept and its key characteristics.
SAFE (Simple agreement for Future Equity) is an agreement between the prospective investor and a company to make cash investment that provides rights to investor for future equity, subject to some parameters, in the company without determining a specific price per share at the time of the initial investment.
Following are the key characteristics of a SAFE agreement:
The SAFE agreement investment is generally for the early seed stage start up companies before the priced-round investment. The SAFE investor receives the future shares when a priced round (vs. a convertible note) of investment or liquidation occurs. Priced round is an equity – based investment round in which there is a pre-money valuation.
The investor under SAFE agreement are generally friends, relatives or any other Angel Investor.
A SAFE is not a debt instrument, but is intended to be an alternative to convertible notes that is beneficial for both companies and investors.
SAFEs are intended to provide simpler mechanism for start-ups to seek initial funding than convertible notes. SAFE primarily comes to play for a start- up company when it is difficult to assess the investment value of a company when there is little data available.
In the event the company fails, the liability is on the company, not on the founder and promoter of the company.
After a seed round of financing, the company will likely need to raise more money to finance the OPEX and Capex/Lease financing and at this stage the company needs to be valued for Round-1 investment. When someone decides to invest in the Round-1 financing - a “priced round” - SAFE will turn into the shares of the company.
In general, SAFE agreement have common terms and parameters as to how the equivalent amount of SAFE investment gets converted to share and the derived price per share at the time of price-equity round financing. Those parameters include: Discounts, Valuation Caps, Most Favoured nation provisions and pro rata rights.
Impact of Discount to SAFE Investor
The SAFE investor invests before any other investor comes in. In this context, sometimes the SAFE investor might want the SAFE to convert to equity at a discount at the time of price to equity (round-1 financing) round. The discount typically ranges between 10-30%.
Impact of Valuation CAP to SAFE Investor
Valuation Cap is another term the SAFE Investor uses to get a better price at the Price-Equity round than the Price-Equity Investor. If the start-up company ends up raising money at the valuation above the “CAP”, then the SAFE investor gets to convert at a share price equivalent to CAP.
In a scenario, wherein SAFE Investor have both a CAP and a discount, the SAFE Investment holder will pick up the CAP or discount to use depending upon which scenario gives the SAFE holder better Price/Share and more no of shares. From our case study, SAFE Investor will opt for CAP as it gives a better unit price/share and larger number of equity shares.
Most Favoured Nation Provision in the SAFE agreement
In a scenario where there are 2 SAFE Investor and second SAFE Investor has a better term than the First SAFE Investor, the founder of the company has to tell the first SAFE Investor about it and the first SAFE Investor can ask for the same term as the second SAFE Investor. This is subject to the terms stated as MFN (Most Favoured Nation) provision in the SAFE agreement of first SAFE Investor.
Pro Rata Rights Provision in the SAFE agreement
The Pro Rata rights is also called the Participation Rights. With the Pro Rata Right, the SAFE Investor can invest additional funds to maintain their ownership percentage during the price-equity financing round subsequent to the financing where the SAFE converted to equity. If exercising pro rata rights, the Investor pays the new price of the round rather than the price they paid when the SAFE initially converted.
Stay tuned for more in startup valuation in two weeks!