Creating a Simple Agreement for Future Equity (SAFE)

A Simple Agreement for Future Equity or SAFE is a non-debt financial instrument that provides an investor with the right to equity at a later date in repayment for their investment. First offered in 2013, SAFEs have gained popularity among startups and early-stage companies. Business disruptors such as Airbnb, Instacart, and Uber secured their financing through SAFEs.

SAFE agreement highlights

What’s most important to recognize about SAFEs is the “future equity” portion. Making an investment in a startup with a SAFE doesn’t grant the investor rights to current equity. Instead, the SAFE's conversion terms must be met before they receive their equity stake. Generally, this threshold is set at a specific amount of funding, and when that amount is met, investors get access to their equity. Unlike debt instruments, SAFEs don't earn interest and have no repayment terms.

Key facts:

• SAFE stands for Simple Agreement for Future Equity
• A SAFE investment is most commonly used by early-stage startups
• Investors only gain access to equity once certain events are met, such as an acquisition or a set amount of funding is reached
• SAFEs do not accrue interest and don’t have a maturity date

How does a Simple Agreement for Future Equity work?

A SAFE is a quick and easy way for a startup to receive an investment without determining the company’s value or issuing equity. They’ve become popular as a faster and more founder-friendly alternative to equity financing or convertible notes. 

When an investment is made, the SAFE investor doesn’t receive immediate access to equity. Instead, their investment only converts once a predetermined event occurs. Triggering events or conversion terms could be:

• Initial public offering (IPO) or other liquidity event
• Sale of the company
• Acquisition
• Set level of financing reached

SAFEs were debuted in 2013 by Y Combinator, a venture capital firm and startup accelerator credited with launching more than 4,000 companies. In 2018, Y Combinator debuted the post money SAFE, which assesses equity ownership after all SAFE money is accounted for.

Since their debut, many startups have used SAFEs as their main tool for early-stage fundraising.

Benefits of using SAFEs

Part of the popularity of SAFEs is due to the wide range of benefits they can offer both startups and investors. A SAFE allows startup founders to get access to much-needed financing while investors receive a discount on future equity. 

Simplified process

A simple agreement for future equity really does live up to its name. One of the overarching reasons both investors and startups like SAFEs is the simplified process. This allows startups to focus on the business instead of raising capital.

The agreement is generally shorter and less complex than other startup financing options such as traditional equity and debt financing. With fewer variables to negotiate and less to understand, negotiations between investors and startup founders are much faster. This saves everyone time, money, and energy.

The simplified process also allows investors and founders to sign a contract and wire the investment funds whenever they agree to. Typical funding instruments require a lot of coordination to get investors aligned and for all investors to wire money on a single close date. SAFEs eliminated that headache.

Reduced legal costs

The average SAFE from Y Combinator is just six pages long. A shorter, simpler agreement means lawyers spend less time negotiating and reviewing documentation. This gets the money into a founder's hands faster and keeps both investors and founders from paying exorbitant legal fees. 

Flexibility in terms

Due to their simplicity, SAFEs offer future investors and founders a lot of flexibility. The terms of a SAFE can be customized to fit the specific needs of a startup's growth strategy. Flexible terms include whether or not valuation caps and discount rates are applied and what those terms will be. 

Non-dilutive funding

One struggle that founders make with traditional financing is balancing getting the investment funds they need while retaining control of equity and decision-making for the company.

A SAFE allows startup founders to receive funding without initially turning any control over to investors. This is considered non-dilutive funding because it doesn’t dilute the founders' equity stake or control over the company.

Founder-friendly agreements

SAFEs provide a win-win situation for startup founders. Founders can get the money they need to run the company from investors without turning over too much equity, valuing the company too early, or accruing debt.

Unlike traditional financing, a SAFE doesn’t require interest payments or have a maturity date. This means that founders can focus on growing the company instead of keeping track of interest payments or asking for extensions. 

If the SAFE never reaches maturity, or never hits the conversion term as set in the agreement, founders have no obligation to repay their investor's principal investments. This lessens the financial risks for founders who are trying to start a company. 

Since an investor's return is tied directly to the success of the company through equity, they’re motivated to ensure the company succeeds. This means investors may contribute more than just money and also offer mentoring and connections to industry contacts. 

In summary, SAFEs benefit founders by:

• Not requiring early company valuation
• Having no maturity date
• Not acquiring interest payments or debt
• Not requiring principal repayment if maturity is never reached
• Encouraging investors to offer more than just money

Investor-friendly terms

While SAFEs don’t require principal repayment if maturity is never reached, which can increase the risk slightly for investors, there are plenty of benefits investors receive from these types of agreements.

Investors receive: 

• Discounted rates on equity
• Valuation caps

Early investment in a startup comes with risks. To offset these risks, SAFEs allow investors to receive a discount on future equity or set a valuation cap. This means that early investors will pay less for the same percentage of equity in a company. These initial investments are also typically lower than in a future priced round. This incentivizes early investment in startups.

With lower costs to invest, the main benefit investors receive from participating in SAFEs is a large payout from selling their equity if the company succeeds.

Clear exit strategy for investors

A benefit for both investors and startup founders is that SAFEs include a clear exit strategy for safe investors. Once the startup reaches the conversion terms, investors have two choices:

1. Hold onto their equity in the startup company
2. Exit through a secondary sale, acquisition, or IPO

These simple terms and options are reasons both investors and founders like SAFEs. 

Potential risks and considerations

As with any type of investment instrument, there are risks to SAFEs, both to investors and founders. Potential risks include:

• Overvaluations
• Unexpected dilution
• Never reaching maturity
• Lessened tax write-offs

Risks and drawbacks

Both founders and investors face specific risks and drawbacks when entering into a SAFE. It’s on each party to weigh whether the benefits outweigh the risks in each scenario and for individual startups.

Potential risks for investors include:

• Never reaching maturity: It’s possible that a startup will never reach its conversion terms or maturity. This means that investors are less likely to recoup their initial investment and will never receive equity in the startup.
• Lack of immediate control: Unlike other investment tools, SAFEs don’t provide investors with immediate ownership or voting rights. And, if the company never reaches its conversion terms, investors never gain ownership or voting rights.
• Lessened tax write-offs: Because the holding period begins upon stock issuance, not signing, investors might miss the cutoff date for significant tax write-offs.
• No liquidation protection: If a startup doesn’t reach its conversion terms and must liquidate or close, investors have no protection similar to what they’d get with other types of investment.

Potential risks for founders include:

• Unexpected dilution: SAFEs initially lower the risk of founder dilution. But, if a startup runs multiple rounds of SAFE investments, they can find their voting rights and company control diluted. 
• Overvaluations: By deferring company valuation until a later round of funding, startups run the risk of overvaluing their company, which can be harmful in the long run. It may make it harder to raise more funds or satisfy initial investors.
• Over-simplified agreement terms: While also one of the greatest benefits of SAFEs, if not managed properly, the simplified terms can also be a drawback. If founders raise too much money with SAFEs and the startup converts, they may find they’ve given away too much control over their company and be surprised to find it diluted.

Legal considerations

While the terms of the agreement under a SAFE are simple, there are still legal considerations to keep in mind for both investors and founders.

At the time of signing, a SAFE is considered a derivative contract. That means they’re regulated by contract law. It’s an agreement signed by two parties that states one party’s rights to future equity when certain terms and events are met. That’s a contract. 

When the conversion terms are met, the legal requirements change.

When investors gain access to equity, the shares are considered securities and are now regulated by securities laws. The securities gained by investors must be registered or filed as exempt with the U.S. Securities and Exchange Commission, or SEC. Generally, a Regulation D filing must be made within 15 days of the first investment. 

It’s important to be monitoring and have the legal paperwork ready when a startup is getting close to reaching its conversion terms. Once investors gain access to equity, you’ll want to be able to quickly and efficiently submit the proper paperwork to the SEC. 

Alternatives to a Simple Agreement for Future Equity

As an alternative to a SAFE investment, founders might consider seeking financing through a variety of funding options, including traditional equity financing, convertible notes, and debt financing. Each has its own benefits, considerations, and features.

SAFE vs. traditional equity financing

This type of financing involves founders selling equity in the company to investors.

• Pro: For investors, this offers immediate ownership control over the startup. Similar to SAFEs, this type of financing also doesn’t earn interest, which can be a benefit to founders. 
• Con: For founders, this type of financing requires company valuation prior to the sale of equity shares. This means founders might undervalue their company initially.

SAFE vs. convertible notes

A convertible note is a type of bond that the investor can convert into equity or stock shares when certain triggers are met.

• Pro: Investors get creditor rights until conversion, which can protect investors if conversion isn’t reached and the startup must be liquidated. Similar to a SAFE, investors receive a discount when converting to equity.
• Con: This type of investment strategy does accrue interest, which can increase costs for the startup.

SAFE vs. debt financing

Debt financing is when startup founders take out a loan to fund their startup. A loan accrues interest, has a set maturity timeline, and must be repaid.

• Pro: For founders, debt financing allows them to get cash without turning over any stakes in the company.
• Con: This type of financing does earn interest, and the debt must be repaid when the loan comes to maturity. 

FAQs

How are SAFEs taxed?

The initial investment in a startup under a SAFE has no tax liability. Once the conversion terms are reached and the investment turns into equity, then it becomes taxable.

Any gains above an investor’s initial input are taxed as capital gains if the shares are sold. For the startup, any proceeds from investors are considered taxable revenue.

How does a valuation cap benefit an investor?

A valuation cap is designed to reward early-stage investors who take on more risk by investing at an earlier stage.

A valuation cap sets the maximum value in equity for the SAFE. If a company’s valuation is higher when a triggering event occurs, the SAFE is converted using the value of the valuation cap.

What happens if a startup fails before a SAFE converts to equity?

If the startup fails before an equity issuance, the investors have very little protection. Unless stated in the SAFE terms, the startup doesn’t have to repay the principal investment, and investors have no access to company equity.