Convertible notes are popular financing instruments for structuring seed-stage investments because they offer a simple, cost effective means of documenting seed capital investments. The “Simple Agreement for Future Equity” (SAFE), a relatively new financing instrument, offers a less common, yet operationally similar, alternative to the convertible note that arguably outmatches the convertible note in both its simplicity and cost of documentation.
Like a convertible note, the SAFE is intended to convert into equity during a future round of capital meeting the parameters set forth in the instrument (“Equity Financing”). Unlike convertible notes, however, SAFEs are not debt instruments, which means (among a slew of other potential benefits to startups) they do not accrue interest or mature. These distinguishing features of SAFEs provide founders of startups with (i) protection from additional dilution via conversion of accrued interest and (ii) flexibility in timing the company’s next financing round. While the absence of a maturity date affords flexibility to founders, it may make some investors wary: if an Equity Financing never occurs (i.e., conversion of the SAFE is never triggered), the SAFE will remain outstanding indefinitely, until the company is sold or liquidated.
SAFEs are touted for their simplicity because they can involve even fewer negotiated terms than convertible notes. While variations of the instrument with additional negotiated terms (e.g., discounts on conversion) are available, the standard form of SAFE requires agreement on only one term: the valuation cap (i.e., the maximum valuation at which the SAFE holder’s investment will convert into equity during an Equity Financing). Plus, since SAFEs are intended as standalone instruments, startups may negotiate SAFE investments on an investor-by-investor basis without the added burden of coordinating a single closing or building consensus among a number of dissimilarly situated potential investors.
As with any financing instrument, SAFEs come with certain limitations and drawbacks. Despite its acronym, the SAFE is not a foolproof financing instrument, and issuing SAFEs without understanding their potential impact with respect to dilution and the future valuation of the company could result in unintended economic outcomes that are ultimately less favorable for startup founders than issuing seed equity. Also, because the instruments are relatively new, the proper tax treatment of SAFEs is uncertain which, when combined with the absence of a maturity date, may render the SAFE a difficult investment for potential investors to analyze.
As with any capital investment transaction, founders of startups must carefully consider the structure of seed-stage investments in light of the company’s long-term goals and anticipated financing needs, and the importance of conducting any investment transaction in compliance with federal and state securities laws cannot be understated.
