SAFEs: What are they and when are they used?

SAFEs: What are they and when are they used
Written by: Devan Fafard

A SAFE, short for “Simple Agreement for Future Equity”, is a popular form of early stage outside financing for start-up companies. The SAFE was created in 2013 by YCombinator, the well known start-up incubator, as a quick and easy alternative to convertible notes for seed financing rounds that avoids the quirks of California lending laws.[1] The attractiveness in using a SAFE is, as the name suggests, its simplicity in negotiation and execution. The standard form SAFE document is quite short and, by design, contains few negotiable terms. Another attractive feature is that it piggybacks off of future valuation work by institutional investors, converting into shares of the company in relation to a future priced financing round. This allows a seed investment to be made without undertaking the arduous work of trying to value a company in its infancy.

Negotiable Terms
The terms of a SAFE that are meant to be negotiable, besides the amount of the investment, are the discount rate to the future equity investment that the SAFE will convert at, the financing threshold or “qualified financing” at which the SAFE will convert into equity, and the valuation cap at which the conversion can be priced at.
The discount to the future equity investment may be included to recognize that the SAFE investor invested their funds at an earlier time when the company presumably had a lower valuation. By having the SAFE convert at a discount on a price per share basis to the priced equity financing the SAFE recognizes this time period difference in valuation while still using the valuation work done by the priced equity financing round. The typical discount range is between 10-20%.[2]
The financing threshold provides for the required value of the subsequent equity financing that will automatically trigger the conversion of the SAFE into shares. This sets the minimum financing amount required before the SAFE will convert and the founders will be diluted.
The valuation cap sets the ceiling for the valuation that the SAFEs will convert at during a future equity financing. This term was brought in for SAFE holder protection in response to rapid increases in the value of start-ups.[3] This term functions so that if there is an equity financing at a valuation above the set cap the SAFE will convert as though the financing occurred at the valuation cap amount.[4] This results in the conversion price reflecting the early stage of the SAFE investment and prevents the SAFE investor ownership position being diluted during the subsequent priced financing round past a certain point.

Do SAFEs Make Sense in Canada?
Despite the popularity of SAFE instruments in the start-up community, from an investor perspective they may not be the best financing fit for start-ups in Canada. The SAFE was born as a solution to work around strange lending registration requirements in California.[5] In the absence of these registration requirements in Canada, convertible notes can have longer maturities and provide investors with more downside protection than SAFEs can offer. Canada also lacks the venture capital infrastructure that results in good ideas being subsequently financed and properly valued by sophisticated investors.[6] There is a risk in Canada that either the start-up is not financed at all or is financed and valued by an unsophisticated retail investor who lacks the experience to properly value the venture.[7] Both scenarios are potentially damaging to SAFE investors and indicate that convertible notes may be the better option.
While heralded for their simplicity, it is important to know the pros, cons and mechanics involved in using SAFEs to finance or invest in a start-up business. Seeking out the qualified advice of a legal professional to make sure that a SAFE fits your individual situation is advisable before engaging in this type of seed financing.

Devan Fafard is a member of the BLG Business Venture Clinic and is a 3rd year student at the University of Calgary Faculty of Law   

Footnotes:
[1] Bryce C Tingle, Start-up and Growth Companies in Canada: A Guide to Legal and Business Practice, 3rd ed (LexisNexis Canada, 2018) at 274 [Tingle].
[2] Michael E Reid et al, “Demystifying SAFEs: The good, the bad, and the ugly,” (30 July 2020), online: < https://www.dlapiper.com/en/canada/insights/publications/2020/07/demystifying-safes/> [Demystifying SAFEs].
[3] Tingle, supra note 1 at 273.
[4] Ibid.
[5] Ibid at 274.
[6] Ibid.
[7] Ibid.