SAFE Contracts - The Revolutionary Contract That Changed the Startup Environment

Introduction 

The birth of a startup and its transformation into a successful business can be extremely delicate and often challenging steps—for both entrepreneurs and the investors willing to support them financially.. One of the tools that makes this process somewhat less complicated is the SAFE contract, which we are going to dive into in this article. 

What are SAFEs? 

SAFE contracts, or SAFEs, are a type of contract used by PE and VC funds to invest into startups in a safer way. SAFE is the acronym for ‘’Simple Agreement for Future Equity’’. A SAFE, in a few words,allows the investor to provide funding to the startup only if it performs well.. This happens at the beginning of the relationship between the startup and the investor; therefore, the startup is not entirely evaluated without first having a chance to succeed, but at the same time, the risk allocation for both parties is substantially lower.

What was it like before SAFEs? 

SAFE contracts were introduced in 2013, when Y Combinator released this investment instrument as an alternative to convertible notes.Before SAFE contracts were used, convertible notes were the go-to financial instrument to obtain very early-stage funding. Convertible notes essentially consist of short-term loans that convert into equity (usually shares) during a future financing round, typically at a discount. Investors lend money to startups, expecting repayment or conversion into ownership stakes later, often with an interest rate that increases the conversion amount if not repaid by maturity. 

Comparison to Convertible Notes: 

Startups use convertible notes and SAFEs to raise early-stage funding, but their structures and complexity differ significantly. Convertible notes are loans that accumulate interest and have a maturity date, requiring repayment or conversion into equity within a specific time frame. They provide investors with security as debt instruments while also allowing for flexibility in conversion terms, such as discounts or valuation caps. However, they require more negotiation and legal complexity, which makes them take longer to complete.

SAFE contracts, on the other hand, are simpler agreements that convert directly into equity during a subsequent funding round with no interest or maturity date. SAFEs simplify the fundraising process, allowing startups to postpone valuation while focusing on growth. They are easier to implement but may lack the structured protections of convertible notes.

Both options cater to different investor preferences and startup needs, but SAFEs have become increasingly predominant over the last 10 years.

Advantages of SAFEs 

SAFE contracts offer several advantages for startups seeking early-stage funding. They simplify the fundraising process by eliminating the need for immediate company valuation, which is often difficult for fledgling businesses. Unlike debt instruments, SAFEs do not accrue interest or have maturity dates, reducing financial pressure on founders. Their straightforward structure minimizes legal costs and negotiation time, enabling quicker access to capital. Additionally, SAFEs are founder-friendly, as they don’t require repayment if triggering events like equity financing or acquisitions don’t occur. Investors benefit from discounted equity and valuation caps, which incentivise early contributions while aligning their success with the startup’s growth.

Disadvantages of SAFEs

While SAFE contracts simplify early-stage fundraising, they come with some disadvantages.. First, converting into equity can result in significant ownership dilution for founders, particularly after multiple SAFE rounds. Furthermore, SAFEs lack a fixed valuation at the time of investment, causing uncertainty for both startups and investors about future equity stakes. SAFEs provide investors with limited control rights until conversion, as they do not provide voting power or board representation. Moreover, SAFEs carry high risk since they don’t guarantee repayment or equity if no triggering event occurs. Lastly, tax implications can be complex and require careful planning.

Conclusion

Overall, SAFE contracts have had a great impact on the growing field of VC. They allow for easier contracting, reducing legal fees for startups to a minimum, therefore incentivizing innovation. SAFE contracts are a perfect example of how legal innovation can lead to technological advancement and improvements in the market.

References and Further Reading

“Beginner's Guide to Simple Agreement for Future Equity (SAFE)” (Qapita)

“Creating a Simple Agreement for Future Equity (SAFE)” (LegalZoom)

“Pros and Cons of Using SAFE Agreements for Start-Ups” (LawFuel)

“SAFE Note vs Convertible Note: What’s the difference?” (Harper James)

“Simple Agreement for Future Equity: A General Guide” (ContractsCounsel)

“Simple Agreement for Future Equity Pros and Cons” (Founders Network)

“Simple Agreement for Future Equity (SAFE)” (Carta)

“Simple Agreement for Future Equity (SAFE)” (Management Study Guide)

“Simple Agreement for Future Equity (SAFE) Agreement” (Zegal)

“The Startup's Handbook to SAFE: Simplifying Future Equity Agreements” (Visible)

“Wading through the uncertainty of simple agreements for future equity” (Baker Tilly)