In the world of startups and venture capital, our clients – speaking of project founders – often look for quick, flexible, and efficient ways to raise funds. One of the more recent innovations in this space is the SAFE Agreement.

Standing for Simple Agreement for Future Equity, SAFE Agreements have gained popularity as an alternative to traditional convertible notes or equity financing.

Through this article, we will explore what SAFE Agreements are, their purpose, benefits, drawbacks, and how they are used in practice following a recent engagement that I had to deal with.

Additionally, having seen them in practice, I can confirm their benefits both for our startup clients and the investors we have introduced. To provide a clearer picture, I will share information from one of the projects where we utilized a SAFE Agreement, which proved to be a valuable tool for both parties.

What is a SAFE Agreement?

A SAFE Agreement is a contract between an investor and a startup that grants the investor the right to obtain equity at a future date, typically during a later investment round or another liquidity event, such as an acquisition. SAFE Agreements are not debt instruments, meaning they do not accrue interest and do not have a maturity date. Instead, they offer investors future equity once certain conditions are met, usually upon the occurrence of a priced financing round.

SAFE Agreements were introduced in 2013 by Y Combinator, a startup accelerator, as a way for an early-stage startup financing. They are designed to be simple and founder-friendly while offering investors a fair deal for the risk they take.

The Purpose of SAFE Agreements

SAFE Agreements serve as a tool for startups to raise capital without the complexities and costs associated with traditional equity or debt financing. The main goal of a SAFE is to delay the formal valuation of a company until a future investment round when it is better established and can attract larger investments.

Key purposes of SAFE Agreements include:

• Simplified fundraising: SAFEs allow startups to raise capital quickly without negotiating complicated terms with investors.
• Equity in the future: Investors using SAFEs are entitled to equity when the company goes through its next round of financing, aligning the interests of the investor and startup without immediate ownership dilution.
• Founder-Friendly terms: Unlike loans or convertible notes, SAFEs do not impose interest or require repayment, making them a flexible option for founders.

Key Features of a SAFE Agreement: 

While SAFE Agreements are simpler than many other financing instruments, they do come with a few key features:

1. SAFEs convert into equity when a trigger event occurs, such as a Series A funding round or another liquidity event (i.e. the conversion event).
2. We then have the ‘Valuation Cap’ which sets the maximum price at which the SAFE will convert into equity, protecting the investor if the company’s valuation increases significantly by the time of conversion.
3. Some SAFEs offer a discount on the future valuation, rewarding early investors with a lower price per share compared to later investors (i.e. the discount rate).
4. Unlike convertible notes, SAFEs do not accrue interest, nor do they require repayment if the startup fails.

Benefits of SAFE Agreements

SAFE Agreements have gained popularity for a variety of reasons, particularly for startups and investors looking for a straightforward funding solution.

Here are some of the main benefits:

1. Simplicity and Speed: The simplicity of the SAFE Agreement reduces legal costs and time spent on negotiations, making it easier for startups to close deals quickly. Traditional financing rounds often require extensive due diligence, but SAFEs offer a streamlined process.
2. No Debt Pressure: Unlike convertible notes, SAFE Agreements do not create a debt burden for the startup. Founders don’t have to worry about paying interest or repaying the principal, allowing them to focus on growing their business rather than managing debt.
3. Founder-Friendly: SAFEs are generally considered more founder-friendly than other financing options. The lack of interest payments and maturity dates offers founders greater flexibility. Additionally, SAFEs often defer company valuations until later stages, which can be beneficial to startups that are still in the early stages of growth.
4. Investor Protection: Despite being simple, SAFE Agreements still provide key protections for investors, such as the valuation cap or discount rate. These terms ensure that early investors receive better terms when the SAFE converts into equity, balancing the risk they take by investing early.

Drawbacks of SAFE Agreements

While SAFE Agreements are useful tools, they are not without limitations.

Both startups and investors should consider potential downsides, such as:

1. Lack of Control for Investors: SAFE investors typically do not get voting rights or other control over the company until their investment converts into equity. This can be a drawback for investors looking to have a say in the company’s strategic direction early on.
2. Uncertainty on Conversion: Because the terms of conversion depend on a future financing round or liquidity event, there’s some uncertainty about when (or if) the SAFE will convert. If the startup fails to raise another round, the SAFE may never convert, leaving the investor without equity.
3. Dilution Risk: For founders, one of the risks associated with SAFEs is the potential for future dilution. Since SAFEs grant investors future equity at a potentially discounted rate, the ownership percentage of founders and early shareholders can be reduced when SAFEs convert.
4. No Immediate Equity: While investors using SAFEs are betting on future equity, they don’t own any shares or have any claim on company assets until the SAFE converts. If the company is sold or liquidated before that point, SAFE holders may lose out.

Who uses SAFE Agreements?

SAFE Agreements are most commonly used by early-stage startups, especially those raising capital from angel investors, venture capitalists, or accelerators like Y Combinator. They are particularly popular among companies that are too early in their development to justify a full valuation or those looking to avoid the complexity and cost of a full equity round.

• Startups: Early-stage startups benefit the most from SAFE Agreements due to their simplicity and flexibility. SAFE Agreements allow startups to raise funds quickly without having to lock in a company valuation too early.
• Angel Investors: Angel investors, who are often the first outside funders of a startup, also favor SAFE Agreements. They can invest relatively small amounts of money and receive equity in the future, with the added protection of a valuation cap.
• Venture Capital Firms: Venture capital firms that are accustomed to early-stage investing use SAFE Agreements as a way to enter into high-potential startups quickly. SAFEs provide them with the opportunity to secure equity in the future at potentially favorable terms while keeping the process straightforward.

Example of using a SAFE Agreement

In my practice, I have recently seen firsthand how SAFE Agreements can provide a helpful tool for both startups and investors. Recently, I worked with a number of Cyprus-based gaming startups that are developing innovative online platforms for multiplayer gaming and virtual tournaments and other type of projects.

In a particular case, my client – a gaming company – was in the early stages of growth, having just developed the beta version of a multiplayer game that incorporated blockchain technology for in-game asset trading. Despite early interest from gamers and industry professionals, the company wasn’t generating significant revenue yet and required capital to fund further development, marketing, and user acquisition.

Our clients were looking for a way to raise capital without committing to a full valuation of the company too early, as they knew the company’s value would likely increase in the near future. Additionally, they wanted to avoid the financial burden and complexity associated with traditional equity financing or convertible notes under Cyprus law.

The SAFE Agreement Solution: We introduced the gaming startup to a group of investors, both local and international, who were enthusiastic about the company’s potential but hesitant to make an equity investment at such an early stage. A SAFE Agreement provided the ideal middle ground, allowing the company to raise capital without undergoing a full equity issuance while still providing the investors the right to future equity.

Investor Benefits

For the investors, the SAFE Agreement included a few million Valuation Cap and a 15% Discount Rate. This meant that when the company raised its next round of equity financing, the investors would convert their investment into equity at a lower price than future investors, or based on the Valuation Cap, whichever was more favorable to them.

The result was a win-win for both sides. The gaming company was able to raise the necessary capital to scale its operations without immediate ownership dilution or complicated negotiations. The investors, on the other hand, secured a favorable position in the company, with protections like the Valuation Cap ensuring they would benefit from the company’s success. Several months later, the startup is now about to secure a larger funding round, at which point the SAFE Agreements will convert into equity.

Conclusion

SAFE Agreements offer a flexible and streamlined solution for both startups and investors, allowing them to delay equity discussions while raising necessary funds. Their simplicity, lack of debt, and founder-friendly terms make them an attractive option for early-stage companies. However, like any financing tool, they come with risks, such as the potential for dilution and uncertainty about conversion.

The example of our aforementioned clients demonstrates how SAFE Agreements can effectively bridge the gap between startup fundraising needs and investor expectations. But still, needs proper legal examination, drafting and advisory. For startups and investors alike, understanding the benefits and limitations of SAFE Agreements is crucial to making informed decisions about early-stage funding.

For all enquiries please contact our team of experts at agp@agplaw.com

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