What Is A Simple Agreement For Future Equity (SAFE)?
A simple Agreement for future Equity or Safe refers to a financing contract startups use to raise funds in their seed funding round. It gives investors the right to the company’s future equity like a warrant, but without determining a particular price per share when making the initial investment.
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Source: Simple Agreement For Future Equity (wallstreetmojo.com)
A SAFE can be crucial to a company’s growth as it does not accrue interest, unlike a loan, and is relatively straightforward to create and implement. However, SAFEs convert into equity only if a particular trigger event occurs, for example, an acquisition or a future financing round. One can find such events outlined in the agreement.
Table of contents
- What Is A Simple Agreement For Future Equity (SAFE)?
- Simple Agreement For Future Equity Explained
- Sample
- Examples
- Tax Treatment
- Pros & Cons
- Simple Agreement For Future Equity vs Convertible Note
- Frequently Asked Questions (FAQs)
- Recommended Articles
Key Takeaways
- The simple agreement for future equity definition refers to financing contracts that early-stage startups can utilize to raise funds from investors in their seed financing round.
- SAFE notes allow investors to subscribe to the company’s shares if a trigger event occurs.
- There are various key elements in a SAFE, for example, valuation-cap, discount, pro-rata rights, etc. But, again, individuals can look at a simple agreement for future equity samples to clearly understand such aspects.
- Typically, one can find the simple agreement for future equity discount rates at the top of the contract.
Simple Agreement For Future Equity Explained
The simple agreement for future equity definition refers to a legal agreement between an investor and an early-stage startup that enables the former to invest in the latter immediately in exchange for equity shares they will receive later.
The investor gets the shares only if a certain trigger event mentioned in the agreement occurs in the future. The SAFE term sheet defines the relationship between the investor and the startup. Moreover, it determines how the agreement will work.
Once both parties agree on all the terms, they sign the SAFE. Then, the investor transfers the sum to the startup. Then, the company can use the money according to the agreed-upon terms and conditions.
Individuals willing clearly understand the concept must know the characteristics of this agreement. So, some of the features are as follows:
- Shadow Stock Issuance: The stock issued by startups to SAFE investors is termed shadow stock. Although this stock intended to have the rights identical to new preferred stock, they differ in certain aspects, for example, liquidation preference and conversion price.
- No Interest Rate: Since a SAFE is not a debt, it does not accrue any interest.
- Deferred Valuation Clause: This delays the company’s valuation until a future date.
- No Description Of The Qualifying Equity Round: It is possible to convert a SAFE at any funding round when determining the business’s value is possible. The company does not need to raise any specific qualifying amount for SAFE’s conversion.
Sample
Individuals who wish to get a clearer idea of a SAFE can look at the simple agreement for future equity sample below.
Source: SEC
Some of the elements of a SAFE are company representations, definitions, and event representations. Besides these, this investment contract comes with multiple crucial terms and parameters. Therefore, one must know about them in detail.
- Discount: SAFE may come with a discount to attract early investors. A valuation discount is offered relative to the investors giving funds in the next financing round. Typically, a simple agreement for future equity discount rates ranges from 10% to 30%. One can find the discount at the top of a SAFE.
- Pro-rata Rights: This right provides SAFE investors an extra right to participate in the succeeding funding round to maintain their ownership percentage.
- Valuation Cap: This is the maximum imposed on the valuation at which a SAFE can convert into stock ownership. This enables SAFE investors to benefit from a better price per equity share than entities investing later.
- Post-Money And Pre-Money: These valuation measurements enable a company’s founders and investors to understand the business’s actual worth. Pre-money valuation refers to the valuation before a new investor gives funds. In contrast, post-money is the valuation, including the money raised in that funding round.
Examples
To understand the concept better, let us look at a few simple agreements for future equity examples.
Example #1
Suppose Panther Tees, a startup, raised seed funding worth $20,000 from Matt Smith, an angel investor, using a SAFE with a 50% discount. Two years later, Panther Tees closed its Series A round at a $4 million pre-money valuation at $4 per share.
Although the company’s valuation was $4 million, Matt Smith could convert the SAFE into stock ownership at a discount of 50% on the price of each share. Therefore, he acquired the company’s shares at $2 each. This means that he converted his SAFE into 10,000 shares ( $20,000/2) which would have cost him $100,000 had he not signed a SAFE.
Example #2
Lion Copper and Gold, a Canada-based mining company, announced that it completed funding for Blue Copper Resources Corp, a subsidiary based in the U.S. The former received $2,000,000 by selling shares of common stock via private placement and an additional $867,500 per the conversion of SAFE notes. Lion Copper and Gold will utilize the proceeds for the Blue Copper prospect’s further exploration and to fulfill the targets concerning other green explorations.
Tax Treatment
The tax treatment of a SAFE is unclear owing to the unavailability of Internal Revenue Service Or IRS guidance. The typical method used to tax new derivatives, for example, SAFEs, involves assigning them to multiple transaction categories for which rules exist. That said, one must note that SAFES do not fit accurately into a particular category. Despite being similar to convertible notes, SAFEs are not debt as they do not have interest payments, repayment obligations, maturity dates, etc.
In addition, SAFEs do not have the rights conventionally associated with equity, for example, the right to vote regarding corporate matters and dividend rights. However, their tax treatment can be similar to that of equity as they convert into equity at a later date. The remaining category for SAFE is precisely variable prepaid forward contracts.
After all, both are similar from an economic standpoint. Although a SAFE does not mention the total number of shares investors can obtain and the purchase date, a formula is available to determine such items.
One must not disqualify a SAFE from being treated as a prepaid forward contract. Assuming the tax treatment of SAFEs is the same as a variable prepaid forward contract, the acquisition of SAFEs and the amount received by issuers must not be taxable events. The subsequent share issuance to satisfy the FACE contract is also non-taxable.
That said, if physical settlement occurs, investors’ basis in the shares acquired equals the overall amount paid to obtain the SAFE. Investors’ holding period begins again. This is crucial as the holding period determines whether they are eligible for the gain exclusion under Section 1202.
Let us look at the pros and cons of SAFEs:
Pros & Cons
#1 – Pros
- As noted above, a SAFE does not bear any interest, and with such an agreement, businesses will not have debt on their balance sheet.
- There is no time pressure on businesses to convert a SAFE into equity.
- Issuing SAFEs is a straightforward process. Moreover, such an investment contract is generally standardized.
- SAFE investors can enjoy more beneficial rights than common stockholders.
#2 – Cons
- Getting out of a SAFE contract can be challenging for investors. This is because entities can sell a SAFE after a year from the purchase date, and that too only if they find a buyer.
- SAFE contracts’ standardization inhibits flexibility.
- A SAFE is a high-risk investment as it will not convert into stock ownership until certain trigger events specified in the agreement occurs.
Simple Agreement For Future Equity vs Convertible Note
Let us look at some critical differences between SAFEs and convertible notes.
- A SAFE is not a debt, unlike a convertible note.
- SAFE contracts do not come with a maturity date and interest rate. On the contrary, convertible notes carry an interest rate and a maturity date.
- Unlike a convertible note, a SAFE does not have a minimum limit for qualified financing.
- Issuing SAFE notes is easier than convertible notes.
Frequently Asked Questions (FAQs)
Companies do not record SAFE notes as debt. Instead, venture capitalists expect businesses to present them in their balance sheet’s equity section. Hence, organizations must classify SAFE notes are equity, not debt.
SAFEs are not debt instruments. Hence, they do not come with an expiry or maturity date. This is why investors might have to wait a long time to convert SAFE notes to equity, even if a business reports a profit.
If a SAFE never converts, the investor who gave funds to the startup using this legal contract can never obtain the company’s equity shares. Typically, the contract terms outline what happens if such a situation occurs. That said, in most cases, investors lose the funds they invested in the company using a SAFE.
Investors are cautious regarding SAFE notes as they are not debt instruments, and there remains a possibility that they will never convert into stock ownership.
Recommended Articles
This has been a guide to what is Simple Agreement For Future Equity. We explain its tax treatment, example, pros, sample, & comparison with convertible note. You can learn more about from the following articles –
- Regulation Crowdfunding
- Crowdfunding
- Corporate Venture Capital
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