By Brian Novell and Daniel DeWolf
Historically, most start-up companies were funded either by the offering of equity or by loans in the form of convertible promissory notes. Recently, however, there have been some hybrid instruments created to fund start-ups. Most notably, and quite popular these days, is the use of an instrument called a SAFE. “SAFE” is an acronym for “simple agreement for future equity.” A SAFE is a contract to receive an amount of equity as determined in a future priced round for which the investor pays the purchase price up front. Developed and released in late 2013 by Y Combinator, the SAFE is intended to provide a more efficient, clear, and simple alternative to convertible promissory notes, and notably lacks certain aspects thereof (including a set term, an interest rate, and a maturity date). Despite their name, SAFEs are not always as “simple” as expected, nor are they necessarily “for future equity” if conversion never occurs. Set forth below we discuss the pros and cons of SAFEs with respect to companies and investors.
Pros and Cons for a Company
SAFEs are generally very company-friendly and can provide companies with an effective financing option.
SAFEs may provide efficiency and expediency by use of a simple form. With fewer variables to understand and negotiate, terms can potentially be agreed upon more quickly.
Decreased negotiation time can lead to savings on transactional and legal costs.
SAFEs do not require that interest be paid on the principal amount.
There is no requirement that the company shall repay the investment or guarantee that the investor shall receive equity. The investment shall convert into equity if, and only if, the SAFE’s conversion trigger is achieved pursuant to a subsequent qualified financing by the company.
Unlike convertible promissory notes, there is no deadline for conversion and this provides the company with tremendous flexibility as to timing for a true equity round.
Given the possible need for more extensive review and negotiation, the associated fees of a SAFE financing may be on par with a convertible promissory note offering.
Sophisticated investors may object to using a SAFE. Depending on the respective bargaining power of the parties involved, a company may need to instead offer a convertible promissory note or other financing option.
Pros and Cons for an Investor
A SAFE is not investor-friendly and may be the least “safe” investment tool available to an early stage investor. With no certainty that an investment will ever convert into equity or otherwise be returned, investors should carefully analyze whether their investment decision falls within the range of situations in which the use of a SAFE may make sense for an investor.
Similar to the potential benefits of simplicity to a company, SAFEs may allow investors to incur lower transactional fees and increase the expediency of their investment.
SAFE investors do still receive the benefit of a discount and/or valuation cap (similar to convertible promissory notes), which can add significant value to an investment.
SAFE investors assume most, if not all, of the risk, in that there is no guarantee of any equity ownership in the company. An investor exchanges cash for a hope that a conversion event occurs.
A SAFE holder is not entitled to any company assets in the event of a liquidation.
A SAFE investor cannot declare a default under the SAFE, and therefore has no leverage to force a repayment or a conversion on favorable terms if a company is not performing well.
A SAFE is not eligible for 100% exclusion of tax on gains under Section 1202 of the Internal Revenue Code for qualified small business stock. In the event that the company is not successful, a SAFE would not be considered “stock” that could be written off as an ordinary business loss under Section 1244 of the Internal Revenue Code.
In addition to the negative reasons why a SAFE investor may never receive equity in the company (such as the company going bankrupt before ever consummating a qualified financing), if the company does extraordinarily well and never needs to conduct a financing that meets the conversion trigger threshold, a SAFE investor may also never receive equity in the very most successful start-ups that are capable of self-funding.
SAFEs are certainly a potential fundraising tool for companies, but they include certain attributes that make them very company-favorable and, conversely, not so favorable to investors. While SAFEs have become increasingly popular among companies seeking fundraising efficiency, investors should be wary of becoming SAFE holders when other investment options may be available. However, depending on the situation, the use of a SAFE can be an acceptable choice based on the context and variables in play. Mintz Levin has great expertise in helping our clients develop strategies with regard to SAFEs and the other potential financing options available to companies and investors. Please consult with your legal advisor at Mintz Levin to discuss whether SAFEs makes sense for your next capital raising or investment event.