In a previous publication, we discussed the usefulness of convertible debt financing for seed-stage start-ups as well as some of the potential issues involved. The objective of this second publication is to compare convertible notes with an emerging financial instrument developed by the Y Combinator, a renowned start-up incubator based in Silicon Valley, called the Simple Agreement for Future Equity (“SAFE”).
1. What is a SAFE?
A SAFE is very similar to a convertible note, but without the traditional interest rate and with no maturity date. Like a convertible note, a SAFE enables start-up companies to obtain immediate financing from investors, in exchange for future equity in the company when a financing round takes place, and thus defers the valuation of the company. In fact, an investor who uses a SAFE is buying the right to obtain preferred shares when a financing round does take place. SAFEs may also offer a conversion discount and/or a valuation cap, and this ensures that there is a limit on the conversion price when the investment is converted into equity. The issues involved with these two characteristics are discussed in detail in our previous chapter [add hyperlink] on convertible notes.
There are different types of SAFEs, with or without a valuation cap or conversion discount. The basic form, which is the subject of this publication, includes a valuation cap but not a conversion discount.
2. SAFE vs. convertible note
Interest rate: Unlike convertible notes, SAFEs do not earn interest. That is certainly attractive for the founders, because they have no payment obligations until the financing round takes place. For investors, the fact that no interest is earned means that at the end of the same period, a lower amount will be converted into shares.
Maturity date: SAFEs have no maturity date after conversion, unlike convertible notes. There is also no “eligible financing” requirement, which means that any round of equity financing, with the exception of rounds for issuing common shares, will result in conversion of the amounts invested. These two distinct characteristics of SAFEs provide flexibility for founders in organizing the capital of their company. The fact that there is no eligible financing requirement is also attractive for SAFE investors, since there is no minimum amount that must be achieved before their investment is converted into shares.
On the other hand, the fact that there is no maturity date can mean that no event that would trigger conversion will ever happen — for example, if the company is doing so well that it does not need another financing round. In that case, SAFE investors would not be in a good position to negotiate the terms of their conversion. If there is no financing round to trigger a conversion, the company has no obligation to repay the investor for their contribution. In addition, as long as no conversion has taken place, the investor has no recourse against the company’s assets in the event of liquidation.
Simplicity: The purpose of a SAFE is to provide uniform terms and conditions, with only the valuation cap being negotiated, to enable companies to raise capital quickly while they are developing their products. Investors may also find the simplicity of SAFEs attractive, although some less sophisticated investors will need legal services to understand the implications of this kind of agreement.
Application of securities legislation: Since SAFEs confer an interest in a security, start-ups that want to use this financing instrument must take into consideration the obligations in respect of securities imposed by Canadian legislation. It is strongly recommended that founders consult a legal advisor to ensure that the SAFE is issued in accordance with a prospectus exemption that is in effect under the applicable securities legislation.
3. SAFE variants
Although SAFEs have not yet become the next tool of choice for seed-stage start-ups and investors, other types of SAFE have been developed in the hope of adapting them to the latest trend in the start-up industry.
For example, the Wefunder crowdfunding SAFE incorporates a number of additional protections for managing smaller investments made in the hundreds, and even thousands, online. Similarly, the Keep It Simple Security (“KISS”) has been developed by another incubator, 500Startups. Described as a hybrid of a SAFE and a convertible note, it incorporates characteristics that are more attractive for investors that are normally found in a convertible note, such as the right to information and the right to participate in future financing rounds.
Overall, SAFEs are considered to be an attractive alternative for founders that investors are usually reluctant to adopt. For that reason, in addition to the fact that they have only recently been introduced as a financing instrument in Canada, SAFEs are still an unconventional alternative.