Understanding SAFE Funding

Understanding SAFE Funding

Funding a startup during the early stages can be one of the most difficult parts of getting the enterprise off the ground. You have the idea and a business plan to back it up, but you don’t have the money to fund development or the basic operations of the company.

Under traditional funding models, startups have to make significant compromises to get the money they need. To address some of the issues that commonly come with traditional startup funding solutions, many of these businesses have started to use SAFEs (Simple Agreement for Future Equity) to get the funding they need.

With a SAFE, you have an investment agreement between a startup and investors. Under the terms of the agreement, the investor agrees to provide funding in exchange for a guarantee of equity that will be released upon a future event.

The Advantages for Startups
Under traditional funding models, startups would look to options like issuing convertible promissory notes or holding an early preferred equity round. With both of these options, startups can get the funds they need, but they also come with significant drawbacks.

When you issue convertible promissory notes, you are issuing debt. It comes with things like interest rates and you have to worry about maturity dates. If the maturity date is reached before conversion, the company has to pay the debt back at interest or convert its value into equity.

If the startup chooses to go with holding a round of preferred equity funding, they will have to perform a valuation before the company has a chance to establish itself. This often leads to the company being undervalued and this allows investors to buy a larger stake in the company. Not to mention, a round of early-stage equity funding can be complicated and expensive.

SAFEs get around these issues by putting the entire agreement and all of its terms in one simple document. A SAFE is not debt so it does not accrue interest or have a maturity date. The structure of a safe also puts the valuation process off until later, so the startup does not have to sell equity at the lower valuation that would be likely in the early stages of the company.

The Advantages for Investors
Startups like SAFEs because they allow them to avoid many of the drawbacks that come with traditional funding options. With that being said, the agreement has to offer some benefit in order to attract investors. Otherwise, they would just wait for a priced equity round instead of risking their money in the early stages of the startup.

One of the more common ways a SAFE offers a benefit to investors is by including a discount when priced equity is issued. When the next round of equity financing is held, the SAFE investor gets to convert the value of the contract at a lower price than the new investors who are buying into the round.

Another common feature is to include a valuation cap in the SAFE. This means that when the SAFE converts to equity, there is a cap on how high the valuation can be as it concerns the conversion. This guarantees the investor a meaningful stake in the company even if the real valuation is unusually high.

Some SAFEs may also include provisions for pro rata rights. With pro rata rights, the investor is guaranteed the right to participate in future rounds of funding. Whether they choose to participate or not is usually up to the investor, but this provides the ability to maintain a level of ownership as the company continues to grow.

Infographic created by DFIN, an SEC reporting software company

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