A Simple Agreement for Future Equity (SAFE) is an agreement between a company and an investor that grants an investor the right to obtain equity at a future date if the company sells shares in a future financing.
SAFE is a financing contract that start-ups can use to incentivise employees or to raise funds in seed financing. The basic idea is that the holder of SAFE is an early employee/ investor whose stake in the company will be based on the valuation in the future pricing round of the company.
For more information, check out our guide on Employee Share Scheme / Options / SAFE / Incentives.
Mechanism of SAFE
A SAFE is used where the investor agrees to pay for a certain amount for shares that may be issued to him/her at a later point in time.
The shares are usually issued on the occurrence of a trigger event such as Future equity financing or Sale of the company. The previously invested money will then be converted into the corresponding number of shares based on either a Discount or a Valuation Cap (to be explained later)
A SAFE is a contract between the investor and the company and should contain the following points:
- The definition of a triggering event
- How the number of shares an investor is entitled to is calculated
- Investors right to vote and receive dividends (if any)
- Governing law and jurisdiction
This instrument will expire and terminate upon the triggering events. A binding and enforceable SAFE should also be drafted accurately to reflect the parties’ intention and prevent unnecessary dispute. Check out our Simple Agreement for Future Equity template.
Example
Investor A invests HKD10,000 through a SAFE, the company will utilize that money to start the business. It is unquestionable that HKD10,000 will not get the company very far. After some progress has been made, the company may want to raise more funds to take the company up a notch, that is when the mechanism of SAFE comes into play.
Let’s say investor B wants to buy 10% of the company for HKD1 million, the post-investment valuation of the company would be 10 million.
New investment/Post investment =$1,000,000/$10,000,000 =10 % of the shares
For the sake of simplicity, assuming before the new investment, the company had 9 million shares, the new share price can be calculated as follow:
Pre investment valuation/pre investment capitalization = $9,000,000/9,000,000 shares= $1 per shares
Assuming there is no valuation cap or discount (which will be elaborated later), the $10,000 SAFE will then be converted into 10,000 shares in the company.
Terminology
Discounts are sometimes given when calculating the amount of shares. As SAFE investors make their investment earlier than other investors, they might want to convert their investment at a discount at the later round of financing. For example, let say there is a 20% discount, using the same example, the SAFE investor will get to buy shares at $0.80. And instead of getting 10,000 shares, he/she will get 12,500 shares.
$10,000/$0.8 per share= 12,500 shares
Valuation Cap is another way to reward the SAFE investor for being the first mover. The company will create a maximum cap limit and divide the same amount by the total number of shares issued by the start-up. For example, if there is a valuation cap of $3M dollars. Therefore the share price for SAFE holder would be:
Pre-investment valuation (valuation cap) pre-investment capitalization= $3,000,000 9,000,000 shares $ 0.33 shares
So the SAFE investment of HKD10,000 will be converted to:
$10,000/$0.33 per share= 30,303 shares
A most favoured nation (MFN) provision might be used if there is more than one SAFE created by the start-up at different points in time. Let say after the creation of SAFE “X” for investor A, the start-up creates another SAFE called SAFE “Y” for investor B, which has better terms than SAFE “X”, then investor A can ask for the same terms to be applied equally to SAFE “X” as well.
Pro Rata rights, also known as participation rights, might sometimes be given to the investors, meaning that investors can invest additional money to maintain their ownership proportion during further equity financing after the SAFE investment has been converted into shares of the company. If pro-rata rights are exercised by the investor, he/she would pay the new price of the financing round rather than the price they paid when the SAGE initially converted.
Benefits of SAFE
- A SAFE is considered to be cost-effective when it comes to raising capital for a start-up.
- SAFEs are generally short and thus easy to negotiate.
- The SAFE investment is not recorded as debts in the financial statements.
- The company is not obliged to return the invested amount to the SAFE holders unless there is a triggering event.
Key takeaways:
- A Simple Agreement for Future Equity (SAFE) is an agreement between a company and an investor that grants an investor the right to obtain equity upon a triggering event.
- A SAFE can include Discounts, Valuation Cap, a most favoured nation (MFN) provision and/or Pro-Rata Rights.
Bibliography:
- DocPro, “Employee Share Scheme / Options / SAFE / Incentives” https://docpro.com/cat133/human-resource-employment/employee-share-scheme-options-safe-incentives
