What are SAFE (Simple Agreement) Agreements?
A SAFE (Simple Agreement for Future Equity) agreement is an innovative and flexible legal tool that enables early-stage investment in startup companies before a precise valuation of the company has been established. Through this agreement, investors provide immediate funding to the company during its early development and growth phases, receiving in return a future right to acquire company shares. This right is actualized only upon the occurrence of defined key events, such as a significant future equity financing round, or in the event of the company’s sale or public offering (IPO). The simplicity of SAFE makes it attractive for both entrepreneurs and investors who wish to avoid the complexity and high costs associated with traditional investment agreements.
The SAFE concept was coined by Y Combinator in 2013 as a response to the growing need for a simple, fast, and efficient alternative to conventional investment agreements like convertible notes. Its purpose was to reduce the legal costs and bureaucratic complexity involved in drafting equity-based agreements at such early stages, enabling companies to raise capital quickly and efficiently, focusing on business growth rather than lengthy and cumbersome legal processes.
Unlike traditional investment agreements that grant the investor immediate company ownership or debt instruments that include a maturity date and interest, a SAFE agreement does not grant immediate ownership rights in the company and does not obligate the company to issue shares at the time of signing. Instead, it creates a future, non-binding option that allows the investor to convert their investment into shares only upon the occurrence of a defined “conversion event.” Since it is not classified as debt, a SAFE agreement does not include a maturity date, interest, or a fixed repayment obligation; rather, it relies entirely on a future conversion mechanism. This flexibility makes it a preferred tool among startups in the Seed and Pre-Seed stages.
Key Clauses in a SAFE Agreement
Despite their relative simplicity, SAFE agreements include several essential clauses that define the investment terms, conversion mechanisms, and the investor’s rights in various scenarios:
1. Equity Financing
This is the central clause in a SAFE agreement. It stipulates that when the company raises capital in a significant future financing round (usually above a predefined amount), the investment made under the SAFE agreement automatically converts into shares of the type sold in that round. This conversion often occurs under preferred terms for the initial investor, known as a “Discount” or “Valuation Cap,” which will be elaborated upon further. These terms are designed to reward the investor for the risk they took by investing at an early stage when the company’s valuation is still uncertain.
2. Liquidity Event
This clause addresses situations where the company is sold, merges with another company, or goes public (IPO) before any future financing event has occurred. In such a case, the SAFE agreement grants the investor the right to choose between two main alternatives: receiving their original investment amount back (often with an agreed-upon premium), or converting their investment into company shares based on the company’s valuation at the liquidity event, and receiving their portion of the sale proceeds as a shareholder. This choice allows the investor to maximize the return on their investment according to the company’s value at the time of exit.
3. Dissolution Event
This clause addresses the less desirable situation where the company dissolves, enters liquidation proceedings, or becomes insolvent before any conversion event (neither a financing round nor a liquidity event) has taken place. In such a case, the SAFE agreement grants the investor the right to receive a return from the company’s remaining assets, if any, but only after settling other company obligations to secured and unsecured creditors. It’s important to note that in many cases, especially at early stages, the remaining assets in an insolvency event might be very low or non-existent.
Key Protections for Investors in a SAFE Agreement – Extended Explanation
Although a SAFE agreement is considered “simple” and flexible, it includes important protection mechanisms for investors. These mechanisms aim to safeguard their investment and reward them for the risk taken during the company’s early stages. Understanding these mechanisms is crucial for every investor and entrepreneur:
1. Discount
The discount is one of the most common protection mechanisms in SAFE agreements. It rewards the investor for the risk taken by investing at an early stage, before a clear company valuation has been established. When the company raises capital in a future equity financing round, the investor under the SAFE agreement receives the right to purchase shares at a reduced price compared to the share price at which new investors (“new money”) will purchase them. This discount rate typically ranges from 10% to 25%, but it can vary based on negotiation. For example, if the next round’s investors acquire shares at a value of $1 per share, and the SAFE investor is entitled to a 20% discount, they will receive their shares at a value of $0.80 per share, thus “rewarding” them for the early risk they undertook.
2. Valuation Cap
The Valuation Cap is another critical protection mechanism for the investor. Its purpose is to protect the investor from a situation where the company’s value drastically increases between the time of the SAFE investment and the next equity financing round. The Valuation Cap sets a maximum company valuation that serves as the basis for calculating the conversion of the investment into shares. This means that even if the company raises money in the future round at a valuation higher than the cap set in the SAFE, the SAFE investment conversion will occur at a lower value (the lower of the future round’s valuation or the cap). This way, the investor ensures a more favorable investment valuation, even if the company succeeds beyond expectations. This mechanism is particularly important when there is an expectation of rapid and significant company growth.
3. Dividend Rights
Although it is very rare for early-stage startup companies to distribute dividends in practice, this clause may appear in SAFE agreements. Sometimes the agreement will stipulate a theoretical mechanism for accumulated dividends, or explicitly clarify that the investor is not entitled to any dividends prior to the conversion of their investment into company shares. The purpose of this clause is mainly to clarify expectations on an issue that is not relevant to most startups in the SAFE fundraising stages, but it’s important to ensure clarity around it.
4. Most Favored Nation (MFN) Protection Clause
The Most Favored Nation (MFN) clause is an important protection mechanism that ensures the current SAFE investor will not be disadvantaged if the company signs future SAFE agreements with better terms. This clause grants the investor the right to receive the most favorable terms given to other investors under similar SAFE agreements, if those agreements were signed after their own. In other words, if the company offers a later SAFE investor a lower valuation cap, a higher discount, or any other more favorable term, the original SAFE investor can demand those same terms. This clause protects against excessive dilution or less attractive terms received by the investor compared to others.
5. Early Conversion After a Period (Long Stop Date / Maturity Date)
There are more advanced versions of SAFE agreements that include a clause allowing the investor to demand an early conversion of their investment into shares, even if none of the material conversion events (equity financing or liquidity event) have occurred within a long, predefined period (for example, 2-3 years). This clause, sometimes referred to as a “Long Stop Date” or “Maturity Date” (although SAFE is not debt), aims to prevent prolonged uncertainty and lack of clarity regarding the investment’s future. It allows the investor to become a shareholder even in cases of company “stagnation,” thereby gaining certain shareholder rights, even if a major fundraising round has not taken place.
Tax Implications of SAFE Agreements
It’s important to note that despite their legal simplicity, SAFE agreements have complex tax implications in Israel, differing from those of convertible loan agreements or direct equity investments. The Israel Tax Authority has published specific guidelines on the matter, according to which an investment through a SAFE might be considered “income from business or profession” (trade) at the time of the agreement’s conversion into shares, rather than “capital gain” – a matter with significant implications for the tax rate applicable to the return. The distinction between income types can dramatically affect the amount of tax payable. Furthermore, issues such as the date of the taxed event, the conversion value for tax purposes, and loss offsetting require in-depth analysis. Professional advice from a lawyer specializing in tax law and corporate finance, as well as a tax advisor knowledgeable in the startup sector, is crucial for understanding the specific tax implications for each case and avoiding unpleasant surprises in the future.
Conclusion
SAFE agreements have become a common and essential tool in the world of early-stage startup fundraising, thanks to their simplicity, efficiency, and flexibility for both the company and the investor. They offer a quick and friendly alternative to traditional investment solutions, allowing entrepreneurs to focus on business development without getting bogged down in complex legal procedures during initial stages.
However, it’s important to remember that this is a unique investment tool with distinct characteristics – including some uncertainty regarding future valuation (until the conversion date), the absence of a fixed maturity date (as in a loan), and the lack of physical collateral or immediate control rights in the company. Additionally, the complex tax implications require professional attention.
Before entering into a SAFE agreement – whether you are an entrepreneur seeking to raise capital or an investor looking for investment opportunities – it’s crucial to thoroughly understand the conversion mechanisms, the risks involved in the agreement, and all potential protections. It’s highly recommended to consider the agreement in light of relevant tax and regulatory considerations, and for this purpose, **professional legal advice from a commercial lawyer specializing in technology and venture capital is indispensable.**
Frequently Asked Questions about SAFE Agreements
- Q: What is the main difference between a SAFE agreement and a convertible note?
- A: The primary difference is that a SAFE is not considered debt. It has no maturity date, interest, or obligation for monetary repayment. In contrast, a convertible note is a debt that converts into equity, and it typically has a maturity date and accrues interest if it doesn’t convert.
- Q: Does a SAFE investor receive shares immediately?
- A: No. A SAFE investor receives a future right to acquire shares. Shares are only issued upon the occurrence of a defined “conversion event,” such as a future equity financing round or the sale of the company.
- Q: What is a Valuation Cap in a SAFE agreement?
- A: A Valuation Cap is a maximum company valuation for the purpose of calculating the conversion of the SAFE investment into shares. It is designed to protect the investor and ensure that even if the company’s valuation significantly increases in future fundraising rounds, the SAFE conversion will occur at a more favorable valuation for the initial investor.
- Q: Are SAFE agreements only relevant to startups?
- A: SAFE agreements were developed for startups and are primarily relevant to technology companies in early fundraising stages (Seed, Pre-Seed), where there is uncertainty regarding valuation. They are less common in traditional businesses or companies with stable revenues and clear valuations.
- Q: What are the main risks for an investor in a SAFE?
- A: Key risks include uncertainty regarding the timing of conversion (or if it will happen at all), lack of collateral, lack of control or voting rights until conversion into shares, and complex tax implications that may affect the net return.