by Tony Palladino
In the world of start-ups, entrepreneurs spend much of their energy seeking funding from the investor community, as well as from friends and family. While they would likely prefer to focus their energy on building a solid product, the smart founders recognize the high priority around running and sustaining their business. For the lucky ones, this can involve multiple fundraising sprints over several years. To “cross the chasm” as it relates to their product adoption in the marketplace, founders can lean on various different types of financial investment instruments, such as a Convertible Note, or a Simple Agreement for Future Equity (SAFE), among others. For this discussion, we will focus on the benefits and risks specific to the SAFE agreement.
The SAFE agreement is a simple template or blueprint commonly used by founders and investors to seal their partnership. The SAFE captures in writing the minimum details required to protect and satisfy both parties. The SAFE investment fuels the business for the near future without the complexity of having to negotiate the company’s valuation up-front (as would be required for a Convertible Note). This allows the founders to raise the capital they need to continue their product development, acquire customers and enhance their value creation capabilities – without diluting their precious equity or losing control of their company. This makes the SAFE a highly desirable and popular financial instrument for early-stage start-ups.
The original SAFE agreement was created around 10 years ago by Y Combinator, a start-up incubator, designed to cover the terms around equity rights and liquidity events for both parties, founders and investors. In addition to Y Combinator, Airbnb and Coinbase are good examples of start-ups that had leveraged SAFE agreements in their early-stage of growth.
The SAFE serves as a bridge for the founders by extending the start-up’s cash runway to a future fundraising round. It also serves as a bridge for the investors to convert their investment into real equity at a percentage “discount rate”, often referred to as a “valuation cap”.
Pro tip: When establishing the valuation cap in a SAFE agreement, founders should resist the urge to undervalue their start-up’s potential. A conservative cap may offer short-term security, but it can also dilute the founders’ equity stake down the road when it’s time to convert. Founders can consider including provisions for adjusting the cap in the event of significant growth milestones or changes in market conditions.
Because SAFE agreements are simple and easy, it is quite normal to execute multiple SAFEs over time. Start-up founders should view each SAFE as a foundational building block in the construction of their equity structure and they should seek prompt conversion – liquidity event – when favorable terms arise. Delaying the conversion can lead to a compounded dilution, which could compromise future funding rounds or acquisition opportunities.
To hold a stronger position in the SAFE negotiation process with investors, the founders should leverage their critical mass and selling points, such as intellectual property (IP) ownership, patents pending, product development roadmap, customer and revenue growth, subscription pricing model, strategic partnerships and, most importantly, the strength of the leadership team. Of course, all of these and more should be addressed in the start-up’s pitch deck to investors.
For the early-stage investors, SAFEs offer a lower barrier to entry compared to traditional equity investments, reducing the up-front capital commitment and risk exposure. Having a lower cost of entry, SAFEs also enable more investors to participate in the fun and exciting world of early-stage start-ups.
Unlike traditional Equity Financing, SAFEs offer founder-friendly terms that prioritize flexibility and simplicity. Equity Financing instruments involve issuing new shares, diluting existing ownership stakes. SAFEs, on the other hand, postpone the determination of equity to a future liquidity event, enabling founders to maintain maximum ownership and control over their start-up. Later, as the start-up matures, its founders can (and should) consider alternative funding instruments, such as Convertible Notes or Priced Equity rounds, which offer a different set of benefits often tied to a larger investment. Having diversity among the investment instruments provides start-up founders with greater flexibility, while mitigating the risks around protecting their equity and control.
For the founders of early-stage start-ups, SAFEs provide a simple mechanism to raise capital without having to surrender equity or control of their company, preserving their vision and autonomy as they navigate the early stages of growth.