According to a report by the Small Business Administration (SBA), 33% of small businesses fail within the first two years of their incorporation, while 50% go belly up in the first five years. Funds are vital for the survival of any business. Access to capital determines whether a company will grow, stagnate, or liquidate. But how can businesses raise the money they require to operate and finance their upcoming projects? And what alternatives do they have?
Early-stage startups have various ways to raise funds, from convertible notes to angel investors. An early-stage startup that prefers to raise capital quickly generally follows a streamlined process because weighing all fundraising options can be challenging. But there is one solution to this problem, i.e., The SAFE agreement.
SAFEs are becoming a popular source of fundraising for business startups. Many early-stage startups use SAFEs to simplify and streamline the financing process. SAFE gives angel investors the right to convert their SAFE into equity when the company goes for the subsequent equity financing round or when liquidation occurs.
What does SAFE mean?
Simple Agreement for Future Equity, or SAFE, is a convertible instrument that turns into equity at a specific time. The company’s next pricing round is often during this brief period. After noticing that pre-revenue company founders have trouble raising money, especially in their first round of investment, Y Combinator proposed this idea in 2013.
A type of financing known as SAFE enables angel investors to turn their capital into equity at a future-priced funding round or liquidation event. Businesses use SAFEs to raise money; they don’t give anything at the time of issuance but rather guarantee the investors future shares of stock in exchange for their current investment.
How are SAFEs different from Convertible Notes?
A convertible note is another type of instrument, like SAFEs. It also converts into equity after a particular time. But the convertible notes are debt instruments, which means they come with an interest rate and maturity date. On the other hand, SAFEs don’t have an interest rate or maturity date. However, they do have a valuation cap and conversion discount for investors.
SAFEs and convertible notes both convert into equity at different times. SAFEs convert into equity at the next priced round. In contrast, convertible notes are converted into equity by raising some capital in a price round of around $ 1 million.
For better understanding, let us now understand some terms related to SAFEs:
Some Important Terms to Understand
It would be best if you understood these concepts correctly to fund business startups with SAFEs successfully.
A valuation cap is a maximum valuation that governs the price per share at which investor funds are converted to equity. SAFEs have valuation ceilings that entice angel investors and compensate them for taking a chance on your business.
Suppose the company’s valuation in the price round is higher than the valuation cap of the SAFE. The SAFE will convert into equity at a lower per-share price than the price paid by investors in the priced round.
SAFEs sometimes include a discount rate(Between 10-25%). It’s the rate at which price per share discount is given to investors when their SAFE converts into equity.
In some cases, SAFEs have both a valuation cap and a discount rate. In such scenarios, the SAFE investor has to choose between the lid and the discount they can use.
Most Favored Nation (MFN)
The Most Favored Nation (MFN) clause is part of legal documents of the terms of SAFE for investor protection. It provides that if future SAFE investors receive better terms, i.e., lower valuation caps or more significant discounts, then MFN SAFE holders can receive the same benefits.
Pro Rata Rights
With the help of Pro-rata rights, investors can invest additional funds to maintain their ownership percentage during their equity financings after the financing where the SAFE initially converted to equity.
The priced round at which a SAFE will convert into equity is the qualifying round, sometimes called a qualifying event or transaction. When fundraising occurs with SAFEs, any priced round is considered a qualifying round.
An exit event means a change of control in your company, for example, an IPO or liquidity event. Suppose your company has to go through an exit event before your SAFE converts into equity. In that situation, the revenues will be distributed to the SAFE investors in amounts corresponding to the terms of their deposits.
Now that we have understood important SAFE terminology, let us take a look at some of the advantages and disadvantages of SAFE:-
Advantages and Disadvantages of SAFE for Founders
Quick access to money:- Compared to equity financing, SAFE rounds are free from lengthy negotiations, documentation, or the need to agree on valuation.
Increased Flexibility:- Here, you won’t find any shareholder voting rights or other company control provisions associated with SAFEs. Due to this, founders can focus on running their company with limited investor friction.
Limited obligations:- You have limited responsibilities to anyone in the short term until you raise money in the future. The founders retain complete control.
Expensive at times:- SAFEs can be costly if the company doesn’t meet its projections. Even a small discount or reasonable valuation cap can be much more expensive than expected.
Need help finding investors:- With lead investors taking interest or any good angel network, you may need help finding investors ready to bet on your company.
Advantages and Disadvantages of SAFE for Investors
Appealing to Investors:- Angel investors might be more willing to take a risk in your company as the valuation cap, and conversion discount offers them security.
Rapid access to venture capital: Investors can quickly utilize SAFEs to invest in profitable businesses because they require a few basic terms to be negotiated and a standard format.
Possibility of equity on advantageous terms: The option to convert their investment into equity is given to the SAFE holders, typically in the form of preferred stock. The conversion terms can be better than those provided to later investors, depending on the valuation cap and discount rate.
Long Wait: Since there is no maturity date and no need to go for a priced equity offering, the company has no reason to go forward. As a result, investors might have to wait a while before turning their SAFE into equity.
No interest:- If SAFE is held for extended periods, investors may lose considerable interest.
A SAFE issuance is a good option for early-stage business startups to raise funds. It also allows founders to have significant control over the startup. Documentation is quite simple, and the investment process is streamlined. SAFE can be highly risky for angel investors as they invest in an early-stage startup.
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