By their very nature, high risk investments are the most likely to provide opportunities for high returns. Private equity stakes in small businesses with strong growth potential can be especially rewarding. For this reason, seed accelerators like Y Combinator (YC) agree to provide seed funding for start-ups that can prove their potential. YC, in particular, has funded more than 1,200 start-ups over the past 12 years, including Airbnb, Dropbox, and Reddit. With great volume comes great responsibility, however, to establish efficient procedures and cost-saving mechanisms. Thus, in order to facilitate its seed funding investments, YC has composed a financing document for start-ups in the earliest stages of raising capital, called the Simple Agreement for Future Equity (SAFE).
The SAFE is an investment security which retains the advantages of the industry-standard convertible note without the adverse consequences of a debt instrument. For example, debt instruments are highly regulated, have maturity dates, accrue interest, and create the threat of insolvency. Conversely, SAFEs are able to provide the same level of flexibility as a convertible note with less stress and regulation.
There are four versions of the SAFE financing document to correspond to the four types of convertible note. These documents provide clear and neutral terms that save both parties money on negotiation efforts. Under the terms of a SAFE, the investor makes a cash investment in a company that automatically converts into stock upon a specified event.
Generally, the specified event that occurs will be an equity financing. In this scenario, when the start-up company decides to sell shares of preferred stock in a priced round, an outstanding SAFE will convert into shares of preferred stock. A “valuation cap” allows the investor to convert into equity at a pre-negotiated price or, if lower, at the price of equity issued in the financing. There is no threshold amount that the company must raise to trigger this conversion. As a result, the investor turns into a preferred stockholder and the SAFE terminates.
Alternatively, upon a merger or acquisition, the investor can convert the SAFE into shares of common stock or elect to have its investment returned. If the company goes public, the investor also has this choice. The common stock conversion is also calculated based on the valuation cap. Accordingly, the valuation cap is going to be one of the most important terms that the parties must still negotiate in a standard SAFE. Other negotiable terms may include a discount rate, a most favored nation provision, and pro rata rights.
While increasing in popularity, the SAFE continues to be underutilized due to its novelty. On the margins, an investor may even find that this instrument is too founder-friendly. When the start-up inspires confidence in the investor, however, any enforcement-related drawbacks are more than made up for by the speed, simplicity, and low transaction costs of SAFE financing.
There is one final caveat for unincorporated entities. The SAFE financing documents were designed for corporations only. Accordingly, Limited Liability Companies (LLCs) are going to have to customize their agreements in order to create an investment security without relying on the wrong business organization and related statutes. As a result, despite the availability of YC’s streamlined procedures, SAFE financing for unincorporated start-ups is still going to be a decision best made with the guidance and consideration of an experienced attorney.