By: Alexa Esposito
December 2016
Introduction
As home to some of the biggest pop culture hubs in the world, the West Coast is viewed as a trendsetter for East Coast social and economic development. The West Coast is where celebrities are seen wearing the latest fashions, attending the coolest music festivals, and sauntering down the red carpet of the latest movie premiers. Therefore, it is no surprise that another West Coast-born trend is currently making its way to the East Coast, and no, unfortunately it is not In-N-Out Burger. However, for start-up entrepreneurs seeking investors in early-stage “seed round” financings, this new trend might turn out to be just as appetizing as the prospect of the famous burger establishment. The “SAFE” Agreement, short for Simple Agreements for Future Equity, is the latest West Coast trend making its way East, providing a new investment option for entrepreneurs and investors in the start-up community.
The Traditional Convertible Note
Popularized by the Silicon Valley accelerator Y-Combinator, SAFE agreements provide an alternative to the more traditional convertible note option for entrepreneurs seeking seed round financings. Convertible notes are debt securities issued by start-up companies in exchange for capital from investors. Although convertible notes technically operate as debt, the ultimate goal for an investor noteholder is to turn his/her debt into equity in the company, that is of a value equal to the value of the preferred stock initial investors received in the company’s Series A round, or first round of financing with venture capitalists. As debt instruments that carry the prospect of future equity for investors, convertible notes characteristically contain traditional debt terms and conversion events and prices. Traditional debt terms include: a principal balance, which refers to the amount invested by the investor; a repayment or maturity date at which the note becomes immediately payable by the demand of the noteholder; an annual rate of interest, which may either be added to the principal balance when the note converts into equity, or be paid to the noteholder in cash at the time of conversion or repayment; a discount rate, referring to the lower price per share used when notes convert in the next round of equity financing as opposed to the price per share of the preferred stock the company issues to the new equity investors; and priority ahead of the company’s equity holders in liquidation, meaning noteholders have a claim to the company’s assets senior to other equity holders.
Conversion events specify occurrences that automatically convert an investor’s debt into equity, the most common being a Next Equity Financing Conversion, which is the closing of a subsequent equity financing of a certain minimum size. Once a conversion event occurs, noteholders receive their equity at a conversion price, which is based on the principal and interest balance of their notes, but is a price that is lower than the price paid by the new equity investors. A valuation cap, or a maximum price at which a note may convert into a Next Equity Financing, is often included in a convertible note. This cap is to ensure that noteholders, who contributed a small investment to a company that has subsequently received a high valuation and will be able to support a Series A roundin its Next Equity Financing, will retain a meaningful stake in the company. Because receiving equity in the company is the ultimate goal for investors, conversion events and conversion prices are the most important terms for investors to consider when negotiating their investment instruments.
The SAFE Alternative for Founders
Y-Combinator unveiled its SAFE agreement, which was drafted by attorney and Y-Combinator partner Carolyn Levy, in 2013. The purpose of the SAFE agreement was to create a standardized set of funding terms between start-ups and investors “while deferring decisions about valuation, liquidation preferences and participation rights until later-stage rounds of financing.” The crucial difference between convertible notes and SAFE agreements is that SAFE agreements do not operate as debt instruments. This means that unlike convertible notes, SAFE agreements do not come with a repayment or maturity date, and do not contain many of the debt terms that convertible notes require such as an interest rate. Therefore, the principal amount invested by a SAFE agreement holder does not need to be returned to the investor by a set date in the future. Instead, SAFE agreements remain outstanding until a “liquidity event;” this means that an investor’s investment made via the SAFE agreement will only convert into equity on an unspecified date in the future when a conversion event such as a subsequent funding round, or acquisition occurs.
The absence of a maturity date is one of the reasons why the SAFE agreement has gained traction on the West Coast, and why entrepreneurs and investors on the East are beginning to choose SAFE agreements over convertible notes. Not including a maturity date in an investment agreement helps wary entrepreneurs avoid the dreaded scenario in which a convertible note matures according to its maturity date, ahead of the company’s Next Equity Financing, but before the founders are prepared to repay the investors. Founders in this situation are thereby left to negotiate an extension with noteholders who may try to leverage better terms for their note in exchange for the extension.
The brevity of SAFE agreements is another reason why an entrepreneur may choose to enter into a SAFE agreement, rather than a convertible note. Because SAFE agreements do not operate as debt instruments, the only terms to be negotiated for the agreement are the conversion event and price. Therefore, the SAFE agreement streamlines the investor funding process by shortening the negotiation process and agreement length, and arguably makes the attorney costs for drafting such agreements cheaper as well.
The Not-So-SAFE Alternative for Investors
Investors have become increasingly willing to invest in SAFE agreements instead of convertible notes in an effort to follow the example of Y-Combinator’s popular accelerator program and invest in hot new start-ups. However, while these trendy SAFE agreements provide the benefit of a streamlined process and a lack of debt for entrepreneurs and founders, investors should realize that the SAFE agreement comes with several uncertainties. Because SAFE agreements do not have a maturity date, investors must wait indefinitely for a conversion event to occur in order to receive equity in the company. Furthermore, because SAFE agreement holders are not debt holders and have no right to repayment, investors have no legal claim to the start-up’s assets if the company fails and is forced to terminate operation before a conversion event occurs if the cessation of business is not itself the conversion event. The lack of a maturity date, as well as the lack of an interest rate also raises potential tax issues for SAFE agreement holders, because these are two key characteristics in determining the tax treatment of an equity instrument. Therefore, seed-round investors should consider structuring their investments as convertible notes until the tax treatment of SAFE agreements becomes more certain. Despite the uncertainties that come with investing in company through SAFE agreements however, recent trends have shown that investors are willing to take the risk, in exchange for the opportunity to invest in what could be the next big company to take a particular market by storm.