Everything you need to know about simple agreements for future equity (SAFE)

Imagine you have a groundbreaking idea for a new augmented reality (AR) gaming platform. You’ve already created an MVP and conducted market research, which indicates significant interest from gamers and potential partners. However, you lack the funds to develop the platform further and launch it to market. What will you do? 

If you decide to seek investment to fund your startup, you need to know about SAFE contracts. Our tech lawyers will describe how to attract investment using SAFE agreements and avoid financial risks.

What is a SAFE investment?

A SAFE is a legal agreement between a startup and an investor where the investors will receive the right to convert their investment into equity when the startup undergoes a future financing round. The advantage of SAFE as a financial instrument is that it can be used when a startup doesn’t have a clear valuation. It permits startups at early stages to avoid the complex process of deciding how much a company is worth.

Compared with the Convertible Note, SAFE is much more favourable for startups because it is not a debt instrument. It doesn't accrue interest or have a maturity date for repayment, unlike a Convertible Note, which is essentially a loan.

How does a SAFE work?

A SAFE goes through four stages, from issuance to conversion into equity. Here is the lifecycle of a SAFE:

1. Issuance. The startup and potential investors negotiate the terms of the SAFE, including the principal amount, valuation cap, discount rate, conversion trigger, and any additional provisions.
2. Funding. The investor provides funds to the startup in exchange for the SAFE.
3. Conversion trigger. The SAFE specifies events or conditions that result in the conversion of the investment into equity. These can be financing rounds, acquisitions, IPOs, product launches, or others.
4. Conversion into equity. The investor converts their investment into equity in the startup when the triggering event occurs. At that point, the investor becomes a shareholder in the company.

What clauses must be included in the SAFE? 

Below are the key clauses you must include in your SAFE.

• The principal amount. This clause specifies the amount of money the investor is providing to the startup in exchange for the SAFE.
• The valuation cap. This is the maximum valuation at which the investment will convert into equity when the triggering event occurs.
• Discount rate. It provides the investor with a percentage discount on the valuation of the next financing round when calculating the conversion price.
• Conversion trigger. This clause defines events or conditions that trigger the conversion of the SAFE into equity. For example, raising additional capital in a financing round, the sale of the company, an IPO, or a merger. This event involves a change in the company's financial status, usually resulting in a large inflow of cash. The lawyers’ task is to determine when and how the investor's SAFE investment will convert into equity upon the occurrence of such an event.
• Dissolution event. This event refers to the winding down, liquidation, or dissolution of the company. If a dissolution event takes place before the conversion trigger, the investor will automatically be entitled to receive a portion of the remaining funds equal to the cash-out amount.
• The type of equity. The SAFE sets what type of shares investors will receive, ordinary or preference shares. 
• Dilution protection. This clause protects the investor from potential equity dilution in the event of a down round, where a subsequent financing round is conducted at a lower valuation than the valuation cap. 
• Events of default. The investor can use remedies, such as the right to demand repayment if the startup defaults on obligations.
• Governing law and jurisdiction. This clause specifies which jurisdiction's laws will govern the SAFE investment and where the dispute will be resolved.

We advise including in the SAFE the Non-disclosure agreement to protect confidential information which investors receive during communication. Moreover, it is important to sign a separate NDA before discussions and due diligence, to cover the period before the SAFE has been signed.

Let’s explore an example to better understand SAFE clauses. A Healthcare AI startup was seeking investment from an angel investor. This is an early-stage startup, so it was challenging to determine an accurate valuation for the company. The founders opted for a SAFE and agreed with the investor on the following terms:

• Principal amount: $200,000
• Valuation cap: $10 million
• Discount rate: 20%
• Conversion trigger: The SAFE would convert into equity after the startup's next equity financing round.

The angel investor provided $200,000 to the Healthcare AI startup, which used the funds to develop a platform, secure partnerships with healthcare providers, and refine its product. Two years later, the financing round resulted in a valuation of $10 million, triggering the conversion. Since the SAFE investor had a valuation cap of $10 million and a 20% discount rate, the investment converted into equity at $0.80 per share.

Let’s imagine a different scenario where the Healthcare AI startup faced unexpected challenges that impacted its growth. This led to the founders deciding to raise additional capital in a financing round. However, this round is conducted at a significantly lower valuation than anticipated — $3 million, which is less than the valuation cap agreed upon with the SAFE investor. When determining the conversion price for the SAFE the valuation cap will be used, not the valuation of the financing round. 

There are four types of SAFE investments, depending on what clauses are included in your agreement.

1. Without a valuation cap nor a discount
2. With a valuation cap, but without a discount
3. With a discount, but without a valuation cap
4. With a valuation cap and a discount

The choice between these four types depends on the startup's and investor's preferences.

The SAFE is an easy financial instrument, but sometimes this can be a disadvantage. It’s become so uncomplicated for founders to raise money using SAFEs, that they do so without understanding the impact on the startup capitalization. When the SAFEs convert into equity, founders realize what part of their company they’ve given away and how much it has diluted their ownership.  So, before making a decision to use SAFE, carefully evaluate whether SAFE suits your business strategy.