Sponsored briefing: Understanding SAFEs and complexities in the ‘Simple’

I. Understanding SAFEs

SAFE is an acronym for ‘Simple Agreement for Future Equity’ that is concluded between investors and the target startups; where the investors give the funds to startups in advance, in exchange for a promise from the company to give shares to the investor at a future date when the startup raises money on a priced round. It is possible for the startups to sign SAFEs with numerous investors at the same time with different terms, as by nature, SAFEs let startups reward investors who are willing to move first by taking more risk, with lower valuations.

SAFE was introduced to the startup ecosystem as a funding vehicle in 2013 by Y Combinator to replace convertible notes. SAFEs have been primarily structured to make calculations on ‘pre-money’ as the investments made with SAFEs were not substantial at the time of its introduction. Following the evolution of early-stage fundraising and increase of the popularisation of SAFE in the startup ecosystem, in 2018, Y Combinator have restructured SAFE to make calculations on ‘post-money’ for clearance to both parties; through which the founders have the awareness on how much dilution is caused by each sale, while the investor knows from the beginning precisely how much ownership of the startup he gets for his investment.

II. How do SAFEs work?

Once a SAFE has been concluded, the investor gets a financial stake in the startup which actually is a contractual right to be converted into shares when the pre-agreed event in SAFE triggers the conversion. Such event/s triggering the conversion of SAFE to a share in the invested startup is known as the ‘trigger/ing event’. It should be noted that the investor, even though making the payment in advance via SAFE, will not be obtaining any shares in the startup until the agreed triggering event occurs, and the risk herein to the investor is that such trigger may never take place. Accordingly, SAFEs are not stock certificates, and the investor will not be granted any rights (including any control or information rights) upon signature of a SAFE, unlike a sale and purchase agreement or a subscription agreement which obligates a transaction between buyer and seller or the company, as the case may be. While sale and purchase agreements or the subscription agreements are the most investor-friendly options for investing in a company, SAFEs are the most suitable option for the startups. SAFEs do not address the startup’s current valuation and postpone it to the next round, by contrast in the sale and purchase agreements or subscription agreements, the investor buys shares at the given price per share either from the seller or via subscription to the company.

Furthermore, SAFEs should not be considered as a ‘debt’ instrument, as interest rates and maturity/repayment dates are not found in SAFEs. This way, SAFE becomes advantageous for startups as it does not accrue interest as a loan does.

Depending on the conditions set out by the parties and following the occurrence of the agreed triggering event within the SAFE, the investor can choose: (i) either to convert its investment into equity; or (ii) to receive its investment back. Having said that, the investor is not entitled to claim its investment back until the occurrence of the trigger event. When both parties agree to it, the investor and the startup may also conclude a pro-rata side letter as part of the SAFE investment, by which the investor shall have the right to purchase its pro rata share of standard preferred shares being sold in the equity financing, if a pro rata right to participate in the equity financing is crucial for the investor to make its investment. As soon as the SAFE investment is converted into a company share, the investor will have a pro-rata right to maintain its equity share by participating in subsequent financing round.

One should also bear in mind that since startups may sign numerous SAFEs with various investors, it may force the investor into a partnership with an unwelcome partner. Therefore, it is highly important to comprehend before conversion of the investment into shares, the current shareholding structure of the target startup and existence of any other SAFEs executed by the startup.

III. Common Types of SAFE

Three common types of SAFEs used by companies in the US, are as follows:

1: Valuation cap, no discount

Valuation cap, the most common one, entitles a SAFE holder to convert the SAFE into shares either at the valuation cap or the price of each share for equity financing, whichever is lower. It would be highly beneficial for the investor to determine a well-balanced valuation cap based on the current projections or assets of the startup. To clarify, if the priced round is higher than the valuation cap, then the SAFE converts over the cap, which means that the SAFE holders basically get more shares for the same amount of money than the Series A investors get. Where the cap is higher than the priced round, shares will be calculated based on the priced round price, since SAFE holders put money into the company earlier it would not be fair for them to get a worse deal than the Series A investors (although it is not likely that startups raise priced rounds at lower valuation than that SAFEs).

2: Discount, no valuation cap

Discount price is the lowest price of preferred share offered in a priced round multiplied by the discount rate determined by both parties.

3: Most favoured nation, no valuation cap, no discount

If the startup issues any subsequent convertible securities with terms more favourable than SAFE including, without limitation, a lower valuation cap and/or discount, prior to termination of SAFE, the startup will promptly provide the investor with written notice, together with a copy of such subsequent convertible securities, so that the first investor can benefit from the terms more favourable than its own SAFE.

Combined models
There are other types of SAFEs, not very common but they can be used in different scenarios, such as: SAFEs with valuation cap plus discount; which is not very preferable by the founders, and SAFEs with no MFN, no valuation cap, no discount, which is usually not preferred by the investors because investors naturally wish to receive some bonus of the lower price when their SAFEs convert.

IV. Important Clauses in SAFEs

Equity financing	– Equity financing means a bona fide transaction or series of transactions with the principal purpose of raising capital, pursuant to which the startup issues and sells preferred shares at a fixed valuation. – Enables the investor to convert the SAFE into shares by the investment divided to the lower one of the valuation cap or the price of each share for equity financing.
Liquidity event	– Means a change of control, direct listing or an initial public offering. – Enables the investor to convert the SAFE to either the initial amount of investment made or the amount payable on the number of shares of common shares equal to the investment divided by the liquidation depending on which is higher.
Dissolution event	– Means a voluntary termination of operations, a general assignment for the benefit of the startup’s creditors or any other liquidation, dissolution or winding up of the startup, whether voluntary or involuntary. – Enables the investor to convert the SAFE to either the initial amount of investment made or the amount payable from cash and other assets of the startup depending on which is higher.
Liquidation priority	In a liquidity or dissolution event, the investor’s right to receive its cash-out amount is: – Junior to payment of outstanding indebtedness and creditor claims, including contractual claims for payment and convertible promissory notes which are not actually or notionally converted into shares. – On par with payments for other SAFEs and/or preferred shares. – Senior to payments for common shares (founder’s or employees’ shares).
Termination	– SAFE is automatically terminated if one of the pre-determined trigger events occur and the SAFE is converted.
Miscellaneous	– Neither SAFE nor the rights in SAFEs are transferable/assignable by either party without the prior written consent of the other. – SAFEs will be governed by the laws of the selected US state.

V. Conclusion

Advantages of SAFEs:

• Standardised/relatively simple agreements speed up negotiations/transactions.
• Lesser expenses due to decreased formalities.
• Increased possibility for startups to benefit from investors among different sectors, vice versa opportunity for investors to invest outside of their field of activity.
• No dilution of investors’ shares against other investors investing during the triggering event, ie, at the time of the SAFE’s conversion.

Disadvantages coming with SAFEs:

• Incorrect valuation cap assessment may result in damages for both parties.
• Investors do not even have basic information rights to access company financials.
• Investors may not get their money back due to lack of control over the startup, if the triggering event never occurs.
• One-way ticket due to its untransferable nature.
• Founders residing outside the US can complicate the process.

It should not be forgotten that SAFE is specifically designed to aid the funding of startups at very early stages, therefore it is only recommended to investors who have strong grounds to believe in a startup’s mission, like their product as well as their approach to the market and are willing to take the high risk of losing the entire investment for the sake of it.

As SAFEs are not Turkish-law instruments, we have prepared this general overview to address typical terms and principles of SAFEs and to create an understanding as to how it functions. This article is intended for informational purposes only and is not intended as nor should be taken as legal advice.