Simple Agreements for Future Equity (SAFEs): (Part 2 of 2)

Pros and Cons of SAFEs

SAFEs (Simple Agreements for Future Equity) have gained immense popularity, and for good reason. They provide multiple benefits for both founders and investors. However, like any financial instrument, SAFEs possess their own range of pros and cons, particularly when not utilized as originally intended.

Pros of SAFEs

A significant advantage of SAFEs is their capacity to resolve the impasse often faced in startup funding regarding who else is investing in the startup, especially when compared to traditional priced equity rounds that necessitate all investors to approve a term sheet at once.

This impasse results from investors' typical herd mentality. In traditional rounds, investors may delay their commitments until they observe other notable participants. In contrast, SAFEs enable investors to participate without waiting for others to sign, thereby streamlining and accelerating the fundraising process for startups.

Several additional factors enhance the appeal of SAFEs for startup founders and investors.

Simplicity: SAFEs are straightforward agreements, lowering the time and legal expenses of fundraising.

Rapidity: Standard SAFEs facilitate rapid investment for startups. With standardized terms, there is little need for extended negotiations, allowing startups to concentrate on growth instead of protracted legal matters. As investors do not become shareholders, there is no need for a shareholders’ agreement.

SAFEs enable founders to secure funds quickly and return to focusing on their business.

Flexibility: Unlike convertible notes, SAFEs lack an interest rate or maturity date. Consequently, startups can sidestep the stress of debt repayment.

Valuation Deferral: SAFEs theoretically delay the startup’s valuation until a subsequent priced equity round, usually at Series A. This postponement can be beneficial for both sides, as it eliminates early discussions regarding the startup’s valuation. Dilution is delayed until a later point when the company has sufficient traction to obtain an accurate valuation.

Cons of SAFEs

Despite their benefits, SAFEs have faced ongoing criticism for various reasons.

The main concern with SAFEs is the misalignment of interests between SAFE holders, often angel investors, and founders. Angel investors might pressure founders to stop a fundraising round once the valuation proposed by new investors hits the predetermined cap.

In contrast, founders generally want to explore the market more, aiming for better offers that could lead to less dilution of their stakes in the startup. This conflict can generate tension and disputes during fundraising, possibly affecting the startup' s growth path.

Below are some frequently raised issues with SAFEs.

Investor Uncertainty: SAFEs offer minimal protection for investors if the startup underperforms. Unlike equity investors who enjoy specific rights and preferences, SAFE holders can find themselves in a vulnerable situation if the company faces challenges. Although many angel investor groups claim to avoid SAFEs for this reason, it's arguably a moot point since startups often lack valuable assets and have low salvage value.

Cap Table Complexities: Over time, as more SAFEs turn into equity and multiple SAFEs with differing terms are outstanding, the startup's capitalization table (“cap table”) can become complicated.

Delayed Ownership Rights: SAFE investors typically lack voting rights or influence over company decisions until their SAFE investment converts into equity. This means they may not have a voice in critical matters until much later in the startup' s development.

Possibility of No Priced Round: If the startup fails to issue a priced round of equity shares, investors will in principle not be able to convert their SAFEs into equity.

However, clauses can be inserted into SAFEs that allow for their conversion into stock between the agreed floor and cap valuations, which encourages the use of SAFEs. Additionally, startups seldom reach profitability during a SAFE round.

Conversion into Preferred Shares: SAFEs typically convert into the instrument of the next financing round, often preferred shares with liquidation preferences, which grant investors the right to recoup their initial investment first in the event of liquidation. This situation can result in a complex hierarchy of preferences, potentially diluting ownership and value for common shareholders, including founders and employees, in favor of investors.

Full Ratchet Provisions: SAFEs that include valuation caps can come with full ratchet provisions that favor investors. These provisions are an anti-dilution measure that sets the adjusted option price or conversion ratio at the lowest sale price for existing SAFE holders. Full ratchet provisions safeguard early investors by compensating them for any dilution of their ownership due to subsequent fundraising rounds. This mechanism ensures that their ownership percentage remains intact, even if future rounds are priced lower than the initial round.

However, full ratchet provisions can impose significant costs on founders and might hinder their ability to raise capital in future funding rounds. Providing these guarantees to early-stage investors can be quite burdensome from the perspective of the founders or those investors participating in later fundraising rounds.

In essence, a full ratchet provision may deter the company from attracting new investment rounds, which is why these provisions are typically effective only for a limited duration. In this regard, it is notable that weighted average approaches are often used as an alternative to full ratchet provisions.

Side Letters: To mitigate some of these challenges, investors may utilize SAFE “side letters” that confer pre-emptive rights on future financing, expanded information rights, and sometimes a preference in liquidation. However, this added complexity can significantly prolong the funding process, countering one of the primary advantages of employing SAFEs in the first place.