SAFE: 

Similar to convertible debt, SAFE Holders can acquire equity at a lower price than other investors in later equity rounds because of discount rate and valuation cap. Nonetheless,  SAFE is more favourable to founders because it goes without the interest rate, maturity date and the relevant repayment obligation. That being the case, a SAFE Holder is only entitled to a right to convert their SAFEs into equity in subsequent rounds and SAFEs remain outstanding indefinitely until a conversion event occurs. 

Terms of a SAFE:

Some terms in a SAFE, like other transacting financing instruments, are negotiable. Usually, such terms would include: 

• The amount

• The valuation cap:
  • A ceiling imposed on the price at which a SAFE//convertible note will convert to share ownership in the future, it is a pre-negotiated amount that serves to “cap” the conversion price when shares are issued
  • Investors prefer low valuation caps—so that they could get more equity with a given amount
  • If the company raises money above the cap, the investor can invest at a price equivalent to the share cap

• The discount (if any):
  • e.g. when invest $1000 in return for 10% return, the discount rate is 10%—if the future value is $1100, the present value has to be discounted by 10%, making the current investment worth $1000

• Pre-money or Post-money:
  • They are valuation measurements that can help investors and founders understand the value of a company. Pre-money refers to the valuation before new investor money. Post-money refers to the valuation includes the capital raised

• Most-favored nations (MFNs) provision
  • also known as non-discrimination clauses for same privileges to all investors. For example, if convertible securities are issued to future investors at better terms, the previous investors should also receive those same terms

• Pro-rata rights
  • investors are entitled to add more funds to maintain ownership percentage rights following equity financing rounds and they are going to pay the new price versus the original price

Conversion: 

A SAFE could convert the investment which is by nature a debt into equity during a future round of financing. Whatever the dollar amount is, a SAFE notes can be converted into a preferred cycle.

Articles of Association:

SAFE operates on the basis that the company’s Articles of Association provide for a class of preferred shares. Thus, a company has to ensure that they have created a class of “preferred shares” within their Articles of Association, otherwise safe may refer to non-existent shares that have never been issued.

Equity under Pre-money Valuation:

A pre-money valuation is to value a company before the injection of any capital or investment. It forms the basis for the calculation of the conversion formula: 

Equity% = (Purchase Amount / Pre-money Valuation) 

At the time of safe negotiation, only the Purchase Amount can be determined. To save time determining the valuation, SAFE tends to take pre-money valuation as a yet-to-be-determined x-value. For example, if a investor buys safe at $200 000, and the pre-money valuation in a later equity financing is $4 million, the investor would be entitled to 5% (because of 2/40) of the shares issued in that financing.

Valuation Cap and Discount Rate:

Valuation Cap can be used to protect investors against dilution of their shares. Investors  are allowed to receive preferred shares with a higher liquidation preference and conversion rate, as well as priority on dividends, namely, “SAFE Preferred Stock.” By doing so, the effect of an exceedingly high pre-money valuation can be offset.

Sometimes an investor may request for a discount rate, which applies to the price per share of the Standard Preferred Share, instead of or in addition to a valuation cap. Very often, both discount rate and valuation cap would be provided to investors. These provide investors with two ways to construe the portion of equity they are entitled to. Usually, the way which provides investors with the greatest portion of equity would prevail.

No Maturity Date:

Since SAFE is not a debt instrument strictly speaking, there is no maturity or end date. An end date can trigger a conversion to equity and investors would be entitled to a right to equity conversion via the valuation cap. Hence, investors holding SAFE could be waiting indefinitely as there is no expressly written maturity date.

Pro-Rata Rights:

Pro-rata rights allow SAFE holders to purchase more shares in a company if the Company raises fund in a further round or rounds of financing. These rights are only exercisable after the conversion of SAFE into preferred shares of a Company in equity financing.

Pre-Money Valuation:

It refers to the value of a company before it goes public or receives other investments such as external funding or financing. In other words, a company’s pre-money valuation is how much money a company is worth before anything is invested into it.

Post-Money Valuation:

It refers to a company’s estimated worth after external financing and/or capital injections are added to its balance sheet.

Pros of SAFE:

• Simple to draft:
  • SAFE is simpler than a convertible note. It does not require an end date or interest and is usually a five-page document

• Less negotiable:
  • SAFE does not need much negotiation, which is different from other investments

• Convertible to equity:
  • Investors can convert their investment to equity at a later time, it often occurs when an equity is raised and preferred shares are distributed

• Flexible to new companies:
  • An absence of pre-defined terms and a maturity date provides companies more freedom

• Gain proportional benefits:
  • Investors may be entitled to better benefits in proportion to their original investment after safe conversion. For example, preferred shares could be offered

• Simple accounting requirement
  • Since safe is included in a company’s capitalization table, it solves the need for any complicated tax consequences

Cons of SAFE:

• Risky:
  • SAFE is not an official debt instrument. In other words, they might be never converted to equity and  repayment is not guaranteed

• Too novel:
  • SAFE is a relatively new concept, lawyers and investors may possess insufficient experience to deal with it

• Complex legal jargon:
  • SAFE is not as simple as it is described. Laymen generally feel difficult to comprehend the sections filled with legal jargons

• Distribution of dividends is not mandatory:
  • Dividends do not have to be paid to SAFE holders as those are paid to common shareholders.
  • C.f. However, the real purpose of SAFE is not to be repaid but to gain equity

• Lower returns:
  • SAFE accrues no interest in an investment

• Risk of dilution:
  • There is a potential dilution impact on the valuation of the business in the future

• Compulsory incorporation requirement
  • In order to adopt SAFE, a company has to be incorporated because SAFE is included in a company’s capitalization table

• Need a fair valuation
  • To appraise a company share’s fair market value