Unlocking the SAFE – An Alternative to Convertible Notes

23 February 2016 Technology Transactions Today Blog

With the increasing level of investment in emerging companies, entrepreneurs are being presented with a wider range of financing documents. One of the relatively newer financing instruments is the “SAFE” (simple agreement for future equity). While some founders and investors believe that the SAFE is a more straightforward replacement for a convertible promissory note, others are hesitant to embrace the simplicity.

The Traditional Model

The SAFE is intended to be an alternative to a convertible promissory note. Convertible notes provide for an initial investment by the investor, with accrual of interest and a fixed maturity/repayment date. By their nature, convertible notes provide for priority ahead of equity holders in the event of liquidation. A common area of negotiation with respect to the convertible note, however, is the conversion terms. Convertible notes will generally convert into equity upon an equity financing, a sale of the company, or upon maturity at a fixed price, rather than being repaid. Founders and investors will negotiate and agree on conversion terms, including any discount rate (the percentage by which the conversion price per share may be reduced below the price per share of the equity financing) and valuation cap (the maximum company valuation to be used to calculate the conversion price per share).  Convertible notes generally provide that they will convert at an equity financing at the lower price per share calculated using the discount rate and valuation cap.

The Alternative

The SAFE is a creation of Y Combinator, and is intended to be a more straightforward alternative for emerging companies to understand, negotiate, and implement. Similar to a convertible note, a SAFE provides for certain conversion events with share price discounts, and can also provide for priority ahead of equity holders in the event of liquidation. However, a SAFE is not a debt instrument. It does not accrue interest, and it does not contain a maturity/repayment date. The investment will only convert into equity when the company raises a future equity round or in the event of a sale of the company.

The Benefits of a SAFE

For a company, a primary benefit to a SAFE is that it is not a debt instrument. The investment does not accrue interest, nor does it contain a maturity/repayment date. The company receives much needed funding, without the concern that it may reach a maturity date before concluding an equity financing. With a convertible note, if this happens, the company could need to reengage with investors to renegotiate the maturity provisions, from a position of weakness, in an attempt to avoid repayment or conversion. With a SAFE, there is no obligation to convert or repay the amount of the SAFE investment prior to an equity financing.

SAFEs also require less negotiation prior to the investment. Convertible notes are often part of a round of investment from multiple investors, and the process can include negotiations to the term sheet, convertible note purchase agreement, and the convertible note itself. A SAFE is a single document solution that generally only requires negotiation of the valuation cap that applies to the conversion process. This frees up time and money for the company to invest in growing the business.

Are SAFEs Safe?

While the SAFE may provide a more straightforward financing instrument for emerging companies, most of the benefits of a SAFE favor the company. Emerging companies already present a significant risk to investors. Investors generally look to reduce their risk when possible. Convertible notes are often viewed as the standard instrument for early stage funding, so a company offering SAFEs could be viewed as a more risky investment.

SAFEs also lose the benefit that may be gained by working through a convertible note funding round. While the additional negotiation and coordination of a convertible note round may appear more complicated from the company’s perspective, investors may find comfort in the process. Seeing other investors interested and willing to invest in the emerging company with more extensive representations, warranties and covenants may lead to additional investors or larger investments at the early stage.

In addition, there are potential tax consequences for the emerging company. Because SAFEs are relatively new, there is little guidance as to whether the SAFE should be considered debt or equity for tax purposes. The SAFE lacks both the interest and maturity characteristics of debt, while also lacking the terms and rights of a typical equity instrument, including the right to vote.

Conclusion   

Just like many other popular start-up forms, the SAFE is not a one-size-fits-all solution to early stage financing. It offers a host of benefits for the emerging company, but can be viewed by potential investors as perhaps more risky or too company friendly. Every emerging company should consider and evaluate the benefits and consequences of different alternatives to determine which document is best for them.

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