Small business blog from Farringford Legal

Do you own or run a start-up or a new business looking to raise money? If you were to raise money, and have interested investors, what documentation would you use with your investor? How much time would you have to negotiate the documentation with your investor?

Or, do you invest in start-ups or new businesses and are looking to deploy money and make good investments? If you have identified a good start-up for investment, what documentation would you use? How much time would you have to negotiate the documentation with the start-up or new business?

One of the most commonly used documents to assist both start-ups and investors is the Simple Agreement (for) Future Equity (“SAFE”), which is relatively short 6-7 pages long).

A SAFE note, which stands for "Simple Agreement for Future Equity," is a type of investment contract commonly used in early-stage financing for startups. Developed by Y Combinator in 2013, it is designed to provide a more straightforward and founder-friendly alternative to convertible notes.

Key Features of a SAFE Note:

1. Equity Agreement:

• A SAFE note is not a debt instrument like a traditional loan or convertible note. Instead, it’s an agreement that allows an investor to purchase shares in the company at a future date, typically when the company raises its next round of financing (referred to as a "priced round").

2. Conversion to Equity:

• SAFE notes convert into equity (shares) in the company during a future financing event. The terms of conversion are usually determined by a valuation cap or discount rate, or both, which are agreed upon at the time the SAFE is issued.
• Valuation Cap: A maximum valuation at which the SAFE note can convert into equity. It ensures investors receive a proportionately larger share if the company’s valuation increases significantly before the conversion.
• Discount Rate: An agreed-upon percentage discount on the price per share during the conversion, giving the investor equity at a lower price than new investors in the subsequent financing round.

3. No Maturity Date or Interest:

• Unlike convertible notes, SAFE notes do not have a maturity date or accrue interest. This makes them less risky for startups since there is no obligation to repay the amount or worry about a debt timeline.

4. Investor-Friendly and Flexible:

• SAFE notes are simpler and faster to execute than traditional financing methods. They are standardised and don’t require extensive negotiations, which reduces legal costs and time for both the startup and the investor.

5. Trigger Events:

The SAFE note typically converts to equity when a specific event occurs, such as:

• Qualified Financing Round: The company raises a subsequent round of funding at a specified minimum amount.
• Liquidity Event: A sale, merger, or IPO of the company.
• Dissolution: If the company dissolves, the SAFE investor may receive a portion of any remaining assets, although they are typically last in line after other creditors.

However, is the SAFE documentation really…safe? 

Whilst the SAFE documentation (especially the Y Combinator standard version) is the go-to version for founders and startups to quickly take investor money (as securing funding is a critical step towards growth and success for any business, including startups and new businesses), they are fraught with potential dangers for the founder and startup (as well as investors) if attention is not paid to some of the details and risks of using the SAFE documentation (and its latter implications). 

The main attractiveness for parties to use the SAFE documentation is the speed or (short) time to negotiate and execute. This not only saves time whilst thinking about a valuation for the company but also saves costly legal fees to draft (and negotiate) longer legal documents. But, if you blindly enter into the SAFE documentation (as either a founder or investor) without thinking about and knowing the implications and risks, it could be costly later on, as the saying goes: “Act in haste, repent at leisure”.

Whilst no legal document or legal strategy is perfect, founders and investors each need to consider the advantages and disadvantages for each party and from each different perspective, rather than just signing the SAFE documentation because “it is the thing that everyone else does”. 

Advantages of a SAFE Note for founders:

• Simple setup cuts down on legal fees and time delays, especially in relation to valuation.
• Founders/company do not have to give up equity at early stages (ie no short-term dilution).
• Allows for fundraising before company valuation; 
• SAFEs don’t have maturity dates, so the founder/company doesn’t need to repay or convert to equity until the liquidity event (eg next financing/ funding round).

Disadvantages of a SAFE Note for founders:

• Oversimplification may result in lack of detail and/or specificity in relation to legal rights and obligations.
• If a discount and/or valuation cap is provided to an investor, a SAFE can be expensive if the company at the time of the SAFE miscalculates the discount and/or the valuation cap etc.

Similarly, there are pros and cons from the investor’s perspective which ought to be carefully considered.

Therefore, SAFEs can be safe, but they also can be risky for a founder and/or an investor, if used improperly or if anyone does not understand the risks of entering into a SAFE. 

Don’t kick the can down the road and get into tangles at later stages of your company’s vital growth or your investment, let Farringford Legal assist you with your SAFEs, and guide you to be…safe. 

Thank you to Jon Pham for this article.

Farringford Legal is a partner for growth, providing affordable, expert legal services with a client-centric, entrepreneurial approach. We are not just lawyers; we are allies in your business journey, adapting as your business evolves, deeply trustworthy, always responsive.

www.farringfordlegal.co.uk  |  info@farringfordlegal.co.uk  |  020 8941 7324  

This article is for general information only and does not constitute legal or professional advice. Please note that the law may have changed since this article was published

Share this post: