Banking & Finance and Small Business & Startups

A SAFE investment instrument does exist

August 31, 2014
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I strive to learn something new every day, and today I learned about SAFE — a new investment instrument that’s valuable to entrepreneurs and small business owners.

SAFE was developed in 2013 by the folks at Y Combinator. The name stands for Simple Agreement for Future Equity. You might be asking yourself, “Isn’t that what a convertible note does?” And the answer would be yes, but with a few unique differences.

Like a convertible note, the point of a SAFE is to provide a flexible investment option for seed and early stage companies. Additionally, a SAFE allows investors to convert to equity when a later equity round is raised and preferred shares are issued. A SAFE usually has provisions for early exit (change of control) or dissolution of the company, and it also has preferential provisions for investors, such as discounts and valuation caps. However, there are a few key differences between a SAFE and a convertible note.

First, a SAFE is not a debt instrument. It is not carried as a liability on the balance sheet like a convertible note is, but, rather, it is reflected in the cap table with warrants and options, which are also convertible securities. Because it is not a debt instrument, a SAFE doesn’t have a maturity date nor does it accrue interest. Thus, there is a possibility that it never converts to equity, and there’s no repayment language in the agreement.

Next, the format of a SAFE is designed to be simple and brief (five pages) without the need for negotiated terms. This not only simplifies matters, but also makes it less expensive to execute since an army of lawyers is not necessary. A sample SAFE can be found here, on the CaseText website.

Another interesting difference is the amount of capital required to qualify as a conversion trigger. Most convertible notes require a minimum investment be made in a future equity round before it is deemed a qualifying transaction for conversion. A SAFE does not have a minimum stipulation; any amount of money raised as an equity round acts as a trigger for conversion. Investors should find this aspect appealing as it eliminates the worry of if/when a company will raise enough money to be considered a qualifying transaction.

However, one of the biggest differences between a SAFE and a convertible note is the matter of corporate structure. Many early companies start as LLCs, and the convertible note, as a debt instrument, works perfectly well with that form. For a SAFE, however, a C or S corporation is required, since the cap table reflects the value of the SAFE investment, just like warrants or stock options. This aspect could affect as many as 75 percent of startup LLC companies that earn less than $500K in revenue and don’t have any other reason to convert to a corporation.

There are a number of other minor points of difference between convertible notes and SAFEs. For readers interested in more nitty-gritty detail, the blog post by Gordon Daugherty at Shockwave Innovations titled “Reviewing the New SAFE Investment Instrument” is a good place to go. 

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