SAFE Agreement - Ultimate Review Guide
This guidance is an essential resource designed to provide a comprehensive overview of reviewing Simple Agreement for Future Equity (SAFE) documents. We wish to provide a valuable tool for entrepreneurs, investors, and legal professionals navigating the complexities of SAFE agreements. Our objective is to present clear, concise, and professional insights into various aspects of SAFE agreements to ensure a thorough understanding and effective evaluation.
SAFE Agreement: Types, Valuation Methods, and how to us it in transaction
1. What is a SAFE Agreement?
A SAFE is a financing tool used by startup companies during their initial seed capital phase, known as seed round or seed financing. These agreements facilitate investment by providing investors with rights to future equity in the company. Characterized by their simplicity and brevity, SAFE agreements typically involve fewer negotiated terms than traditional financing options, potentially reducing legal expenses.
2. Types of SAFE Agreements
SAFE agreements come in several varieties, mainly differing in their valuation basis and additional financial terms:
a. Valuation Basis: Pre-Money vs. Post-Money
- Pre-Money SAFE: This type of SAFE agreement calculates equity conversion without including the conversion of the SAFE itself. It is generally considered more favorable to the founders, as it does not fix the investor's ownership percentage at the time of the agreement.
- Post-Money SAFE: Introduced by Y Combinator in 2018 as a modification to the original SAFE, the post-money SAFE includes the conversion of the SAFE in the equity conversion calculation, thereby setting a fixed ownership percentage for the investor. This clarity of ownership share makes post-money SAFEs more investor-friendly but increases the risk of ownership dilution for founders.
b. Financial Terms: Discount Rate and Valuation Cap
- Discount Rate: This term allows investors to convert their SAFE into equity at a price lower than the valuation set in a future financing round, rewarding early investment.
- Valuation Cap: This is a maximum valuation at which the SAFE will convert into equity, protecting investors from overvaluation in future rounds.
3. Usage in Transactions
The choice between a pre-money and post-money SAFE, and the inclusion of terms like discount rates and valuation caps, depends on the specific needs and bargaining positions of the parties involved:
- Pre-Money SAFEs are typically used in transactions where founders wish to retain greater control over ownership percentages and are in a position to negotiate terms more favorable to themselves.
- Post-Money SAFEs are common in scenarios where clarity of future ownership percentage is crucial for investors, and where founders are willing to accept potential dilution for the sake of investment certainty.
How to review the Conversion Triggers in SAFE Agreements
Conversion in a SAFE agreement refers to the conditions and process whereby the investor's right to future equity is transformed into actual equity shares. This transformation typically occurs upon specific triggering events. Common triggering events include:
- a qualified financing round: for example next round equity financing;
- a liquidity event: sale of the company or an Initial Public Offering (IPO)；
- reaching a specified maturity date;
- dissolution or Bankruptcy.
Review Tips
- Ensure that the agreement explicitly defines each trigger event. Vague terms can lead to disputes and complications during conversion.
How to Review the SAFE Price, Valuation Cap, and Discount Rate
What are they?
- SAFE Price: The amount paid by an investor for a SAFE, representing a future right to purchase equity.
- Valuation Cap: A pre-agreed maximum valuation at which the SAFE will convert into equity. It caps the price at which the SAFE converts, protecting the investor from dilution in high-valuation future financing rounds.
- Discount Rate: A percentage discount given to SAFE holders on the price per share of equity in the next financing round. It rewards early investors by allowing them to convert their SAFE into equity at a lower price compared to later investors.
Review Tips
- Reviewing Valuation Cap:
- Ensure the cap is fair for both parties. It should not undervalue the company nor over-penalize future investors.
- Example: Understand how the cap affects the conversion price. E.g. If a company’s valuation in the next round is $10 million, but the cap is $5 million, the SAFE converts at this lower valuation, effectively giving the investor more shares.
- Reviewing Discount Rate:
- Check if the discount rate is appropriate for the risk the investor is taking. Typically, higher risk warrants a higher discount.
- Example: If the standard share price in the next round is $12 and the discount rate is 25%, SAFE holders convert at $9 per share.
- SAFEs with Both Valuation Cap and Discount Rate:
- The lower of the two conversion prices (valuation cap implied or discount rate implied) should apply.
- Example: If the valuation cap implies a conversion price of $7/share, and the discount rate implies $6/share, the latter would apply.
Most Favored Nation (MFN) Rights:
MFN rights ensure an investor receives the same favorable terms if such terms are later offered to other investors in subsequent deals.
- Review Tips: Scrutinize the scope and applicability of MFN clauses. Consider future fundraising scenarios and how these rights could impact negotiations with new investors.
Preemptive Rights:
These rights allow investors to purchase additional shares in future funding rounds to maintain their ownership percentage.
- Review Tips: Evaluate the potential impact on the company’s cap table and existing shareholder dilution. Consider setting clear guidelines for the exercise of these rights.
Major Investor Rights:
Special rights granted to investors who meet a certain shareholding threshold, often granting them additional influence or privileges.
- Review Tips: Define the threshold for "Major Investor" status and the specific rights conferred. Assess how these rights align with the company's governance and operational goals.
Expense Reimbursement:
A provision where the company agrees to cover certain expenses incurred by the investor, like legal fees related to the investment.
- Review Tips: Ensure the terms for reimbursement are clearly defined and reasonable. Consider the potential financial impact on the company, especially if setting a cap on reimbursable expenses.
Financial Information Rights:
The right of investors to receive regular financial statements or detailed company information.
- Review Tips: Determine the frequency and extent of financial information to be shared. Implement confidentiality agreements to safeguard sensitive data.
Director Designee or Board Observer Rights:
The right for an investor to appoint a director or a non-voting observer to the company's board, influencing governance and decision-making.
- Review Tips: Consider the potential impact on board dynamics and company governance. Define the scope of influence and contribution expected from appointed individuals.