SAFE — HIDDEN (UNSAFE) TRICKS
Simple Agreements for Future Equity, popularly called “SAFEs” have become a popular tool for startup fundraising. In simple terms (pun intended), a SAFE is a convertible instrument that allows an investor invest in a startup in exchange for equity or a payout on the occurrence of specific triggering events, such as a liquidity event (sale, merger, acquisition, etc.) or an equity financing. The attractiveness of this investment tool could be attributed to the comparative simplicity, speed and cost-effectiveness of concluding SAFE rounds. Yet, the SAFEs may contain some terms which investors need to look out for. In this piece, we discuss some of such terms.
Investor, look out…
When you receive a SAFE you should run a redline against the standard SAFE template to track changes. Given that SAFEs are a standardized document, it is not unusual to see both parties adopting SAFEs verbatim with changes to just the names of the parties and insertions of terms such as the discount rate and valuation cap. All other terms should not change and you can safely invest.
However, in some cases, certain ”small” changes to the SAFE during the negotiation process could be detrimental to an investor’s interests. With little or no knowledge of the standard terms of the SAFE and in the absence of proper guidance from an experienced attorney, an investor may fall into the trap of accepting terms which may be unfavorable.
Here are a few of such terms to look out for –
· Options for payment upon the occurrence of a liquidity event –Typically, in a liquidity event, most SAFEs grant the investor the right to choose between receiving the greater between the exact investment amount (“Purchase Amount”) and the “Conversion Amount” (i.e. the amount payable on the shares of common stock which the investor would be entitled to receive, upon conversion of the SAFE to equity, which is calculated by dividing the Purchase Amount by the purchase price payable in connection with the Liquidity Event (i.e. the “Liquidity Price”). This gives the investor the opportunity to make a return on its investment. However, startups may include language that gives the Company “the discretion” to select between both options and to the investor’s disadvantage, the Company may select the lower of both payout options. New investors should watch out for such language being included in the liquidity event provision of the SAFE.
· Liquidity Price definition — One advantage of the SAFE is that it allows the investor to convert to shares of preferred stock at the next equity round or liquidity event at a lower price than may be paid by other investors in that round or during the liquidity event, either because of a valuation cap or a discount rate agreed to in the SAFE. In the case of a “discount only’ SAFE, the agreed discount rate, typically between 15–25%, usually applies to both the Conversion Price (i.e., price in the event of an equity round) and the Liquidity Price (price in the event of a liquidity event, such as a merger or an IPO). In some cases, however, some companies tweak their SAFEs so that the discount applies only to the Conversion Price and not the Liquidity Price. In such a case, it is important that the SAFE applies the discount rate to both the Conversion Price and liquidity Price to allow the Investor the option to receive a payout on a higher number of common stock in the liquidity event. An illustration may be helpful here. For an investor with a ‘discount only’ SAFE, the Liquidity Price would be calculated as the: price per share paid in the liquidity event” (PPS) x the Discount Rate (i.e. 100% — discount). Say the investor invests $10,000 via a SAFE at a 75% Discount Rate, in the event of a liquidity event that results in the company’s shares being purchased at $2.00 per share, i.e., a PPS of $2.00, the formula for conversion is — $10,000 / ($2 x 0.75) = 6,667 shares. This means that as a result of the discount, the Investor’s $10,000 purchased 6,667 shares (which is worth $13,333 at the rate of 6,667 shares x $2 PPS), i.e., the investor gained an extra $3,333 over the original investment of $10,000. However, if no discount is applied in calculating the Liquidity Price, the investor would convert at $10,000 / $2 = 5,000 shares and would simply be receiving 5,000 shares (i.e., not 6,667 shares), i.e., no extra payout. In other words, if this discount is not reflected in the SAFE’s definition of Liquidity Price, there would be no real benefit from the conversion of the SAFE at a liquidity event.
· Amendment of SAFE — Usually SAFEs provide two options for amendment, i.e. either with the investor and the Company’s consent or with the Company and a majority-in-interest of all then-outstanding SAFEs (i.e. with the same discount rate or post-money valuation cap as the SAFE which is to be amended). This is important for smaller angel investors that don’t realize their SAFE can be amended without their approval. The amendment protocol is typically a matter of negotiations between both parties, and in some cases the company might take out the first option from the SAFE presumably to prevent a situation where different SAFE investors can amend their SAFEs and have different terms from other investors in the same round. However, this may create a little less flexibility in amendment procedure as it denies the investor the opportunity to make specific changes to its SAFE, such as increase the value of its investment, without seeking the consent of holders of a majority in interest.
· Notice of Amendment — Still on amendment provisions, SAFEs typically provide that in the case of an amendment by a majority-in-interest, the company must seek all investors’ consent before any amendment (even if such consent is not obtained). The absence of this provision may lead to an adjustment of the SAFE by the majority investor(s) without a minority investor’s prior awareness. You would want to know beforehand the decisions that are being taken which may impact on your SAFE, even if you do not technically have a say. Thus, it is important for this proviso to be included.
· Dividends — Typically, SAFEs allow the Investor the right to receive dividends where the company pays a cash dividend on outstanding shares of common stock while the SAFE is outstanding. In some cases, the company may not want to bear this obligation to SAFE-holders who do not yet hold equity and may take out provisions relating to dividends. This is normally a negotiable point, and it is for the investor to decide whether or not the absence of the possibility of a dividend payment would be a deal-breaker.
As an investor, it is important for you to pay careful attention to the terms of SAFEs to ensure that there are no subtle and unfavorable deviations from what is considered market and that your interests are properly protected. If you are uncertain or daunted by the complexity of the terms, you should consult a legal professional to assist in a review.