Is SAFE Really That Safe? Part I

Disclaimer: this post is an opinion which is probably biased by my being an investor. Also, while it does discuss legal issues, it is not a substitute for advice from your trusted lawyer (the writer is not a lawyer).

SAFE has become a very popular seed investment contract. It has many advantages like simplicity (as the name implies), but some disadvantages too.

To understand the pros and cons of SAFE, let’s start with some basics. Funding comes in two flavors: equity and debt. Anything else is a hybrid (like preferred shares) and/or derivative (e.g. stock options).

The standard instrument for startup funding is preferred equity, which is an equity and debt (preference) hybrid with some features that try to balance the interests of founders and investors. Preferred equity agreements usually include:

  1. Preference meaning that investors get their money back, sometime with some upside, before distribution to founders and others. This is also known as waterfall.

  2. Investor rights including board representation; the right to veto some key decisions like fundraising, exit or major changes in the business; and anti-dilution which gives limited protection in a down-round scenario.

  3. Founder restrictions such as reverse-vesting and no-sale, ensuring founders’ long-term commitment and incentive.

A good agreement needs to be long and complex, addressing many possible scenarios throughout the life of the startup. While most of these agreements are almost identical, they usually involve some negotiating and carry a high price tag in legal fees.

For short-term investments, namely bridge funding, the standard is CLA, short for Convertible Loan Agreement. A CLA is debt which converts into equity when a large enough investment round, a.k.a. qualified round, closes. The investment terms, and specifically the valuation are negotiated in the qualified round, and CLA holders get a discount. In many cases there is also a maximum valuation called cap.

Problem is, until conversion, a CLA is debt with all the risks involved. It has a maturity (=repayment) date and pays interest (creating tax issues in Israel).

Founders, who are naturally optimistic, like CLAs because they expect valuation to increase by the next round, reducing their dilution. Investors, on the other hand, get full anti-dilution protection until the next round.

What happens when the CLA matures before a qualified round closes? Some CLAs include automatic conversion at some agreed valuation (e.g. previous round). Others leave the lenders and founders to reach some solution that will prevent default and keep the startup alive.

Not that long ago (2013), Y Combinator came with a new instrument they called SAFE, which stands for Simple Agreement for Future Equity. It was marketed as a startup-and-investor-friendly version of the CLA. Being a Y Combinator product with a catchy name, SAFE became an instant success (yes, marketing works, even for legal documents).

Y Combinator explain that the SAFE is not a debt instrument, meaning that there is no interest or maturity date. It converts automatically when the company issues preferred shares to investors regardless of amount (theoretically a $1 round is enough). But in a liquidation event, SAFE holders are first in line, which does sound a lot like debt.

Startups can (and do) issue multiple SAFE instruments, funding the company for a long time without an equity round and leaving investors with very little say.

Since sophisticated investors understand the limitations of SAFE, many of them do not use the vanilla Y Combinator version, but customize it to include some restrictions, investor rights (before and after conversion), representations and even a qualified round minimum.

So is SAFE better than CLA? The short answer is probably yes, but with some caveats:

  • Founders need to make sure that they do not abuse the lack of investor protection. While the vanilla SAFE allows them to do almost anything, a dispute by investors who feel they were not treated fairly is an easy way to destroy a startup.

  • As a new and innovative contract, SAFE is not yet fully understood by tax authorities and courts.

But is SAFE the magic wand of investment contracts? Stay tuned for part II.