If you are an early-stage founder gearing up to raise capital, chances are you are thinking about a SAFE. A Simple Agreement for Future Equity (SAFE) has become the go-to fundraising instrument for startups at the pre-seed and seed stage. But while SAFEs are designed to be founder-friendly and straightforward, there are a few legal and practical considerations worth understanding before you start collecting signatures and wiring instructions.
What Is a SAFE and How Does It Work?
A Simple Agreement for Future Equity (“SAFE”) is a contractual right to receive equity in the future upon the occurrence of a triggering event, most commonly a priced financing round (such as a Series A). When that trigger occurs, the SAFE converts into shares of the company’s stock. In other words, in exchange for the investor’s cash today, the company promises to issue equity to the investor at a future date. SAFEs were introduced by Y Combinator in 2013. They have since become the dominant instrument for early-stage fundraising, especially post-money SAFEs.
Generally, the valuation cap or the discount rate in the SAFE dictate the conversion terms. The valuation cap sets a ceiling on the price per share at which the SAFE holder’s investment will convert into equity. If the company’s valuation at the time of the priced round exceeds the cap, the SAFE investor gets a better price than the new investors, rewarding them for taking the earlier risk. Some SAFEs include a discount rate instead of a valuation cap, which gives the SAFE holder a percentage discount (commonly 10-20%) off the per-share price paid by investors in the triggering round. Some SAFEs contain both a valuation cap and discount rate, but only one conversion term applies depending on the most favorable result for the investor.
The appeal is easy to understand. The Y Combinator form of SAFE is simple and usually only a few pages long. The model SAFEs check a lot of boxes for founders who want to move fast and keep legal costs down, but there are a handful of issues that founders tend to overlook.
First Trap – Thinking that the Y Combinator SAFE is a “One-Size-Fits-All” Document
Any time a founder takes money from outside investors, the process needs to be carefully evaluated from a legal, financial, and operational perspective. The entering into a SAFE is no different, but often founders skip this step. They simply download an online form, enter the amount and parties’ names, then sign and collect the check from the investor.
I sat across many founders who did not evaluate all the terms of the SAFE and later found out that:
- the document does not work for their company or fundraising strategy;
- the founders will suffer excessive dilution upon conversion;
- the SAFE lacks important legal protections for founders or, in some aspects, it may be too investor-friendly;
Each company has a unique investment strategy depending on the industry, risk, and players involved. Not every founder has the same appetite for risk—some may be willing to take on more risk than others. The standard Y Combinator or other online SAFEs are great instruments for many early-stage companies to raise, but “standard” doesn’t necessarily mean they are the right choice for all companies.
Second Trap – Thinking that SAFEs Are Not Securities and Do Not Require Compliance with Securities Laws
SAFEs fall within the broad reach of the federal securities laws, which define securities expansively to include investment contracts and similar instruments. While initially there was some debate about whether SAFEs were to be treated as securities or not, the SEC has signaled through enforcement actions and public statements that SAFEs are securities.
Yet, many founders fail to evaluate compliance with securities laws at the state and federal level when they accept SAFEs from investors. By doing so, they could be giving investors rescission rights and subject themselves to penalties/suspensions from selling securities, as well as few other legal complexities down the road.
In other instances, founders understand that SAFEs are securities and may trigger securities compliance, but quickly decide not to register the sale and incur additional costs by relaying on a small private offering exemption under Section 4(a)(2) of the Securities Act they heard from others without fully appreciating its purpose and potential limitations.
A Section 4(a)(2) exemption applies to transactions that do not involve a public offering and covers a small, private raise from a handful of sophisticated investors who must be provided with the same disclosure materials that would typically accompany a registered offering. Additionally, Section 4(a)(2) only provides a federal exemption to registration, which means that state “blue sky” laws may still require a company to register the sale at the state level unless a similar state-level exemption applies. Right away, there are some clear limitations with this exemption:
- Founders often target friends, family members and other investors who may not be accredited and, thus, allow the company to qualify for this exemption;
- SAFEs are often issued to multiple investors and, depending on the number, the raise may not meet the definition of a small offering;
- Founders generally do not prepare a PPM or attach extensive information/risk factor disclosures to SAFEs;
- Section 4(a)(2) is a statutory exemption with no bright-line rules and is entirely dependent on a facts-and-circumstances test; and
- Even if all the requirements above are met, the company may still need to register at a state level.
It is common for founders to focus on the “small, private” offering part and overlook the other parts of a Section 4(a)(2) exemption, or ignore state-level compliance.
Third Trap – Thinking That a Form D Filing Doesn’t Trigger State-Level Securities Compliance
Even founders who are fully aware that a sale of securities via SAFEs requires compliance with securities laws and file a Form D with the SEC under Regulation D often neglect state-level blue sky filing obligations. The failure to complete these filings also subjects them to potential rescission rights and penalties.
To provide founders with objective standards that their company can offer and sale securities without registering the offering with the SEC, the SEC adopted Regulation D in 1982. A Form D is a brief notice filing that identifies, among other things, the federal exemption that permits the company to conduct a private placement of securities without the need to satisfy extensive registration requirements. Form D is free of charge and administratively straightforward.
For that reason, founders who raise capital via SAFEs and meet one of the safe harbor exemptions in Regulation D typically file a Form D. But when they then proceed to make state-level blue sky filings, they suddenly get discouraged by the fees charged by one or more states (depending on where the SAFE investors are located) and choose not to file at the state level. It is common for founders to abandon these filings and absorb the risk when they did not properly factor these expenses in the fundraising strategy. However, the refusal to file could lead to significant issues down the road. VCs and institutional investors will scrutinize the sale of securities and expect full compliance with both Federal and state securities laws. Skimping on compliance today can create costly complications when future investors come knocking.
Takeaway
SAFEs are a terrific tool for early-stage fundraising and their popularity is well deserved. But “simple agreement” does not mean “no legal considerations.” Before you launch a SAFE round, take the time to consult with experienced advisors who can help you think through these and other legal, financial and operational questions. More strategical considerations on the front end can save you significant headaches down the road.
