Play it safe with SAFEs

A simple agreement for future equity, known as a ‘SAFE’, is a funding instrument used by founders and startups to secure investment, commonly to raise seed capital before conducting a priced equity round. SAFEs were developed by Y-Combinator in the US as a simple funding document on standard terms, and have been adopted by the Australian venture investing community on ‘localised’ Australian terms.

A SAFE gives the investor a right to be issued shares in the company when a future ‘conversion event’ occurs, with the number of shares calculated at the time of the conversion event. The primary conversion event is the company conducting a priced equity round.

For those looking to use SAFEs, there is general awareness of the need to consider the appropriate discount rate and valuation cap (if these features will apply). For a priced round conversion event, this means that the investor’s investment is converted to shares based on the share price of that equity round multiplied by the discount rate, and provided that the company’s valuation is limited to the valuation cap. These points are well covered by public commentary, as well as the pros and cons of a SAFE over a convertible note. However, there are other issues that parties should consider.

1. Exit Event

Another conversion event in the SAFE will be an “Exit Event”, for example a sale of the company’s assets or shares. The investor can choose between receiving a cash payment equal to their investment, or receiving shares in the company. The relevant question is how the number of shares is to be calculated. This can be by reference to the valuation cap, the share price implied by the Exit Event multiplied by the discount rate, or whichever calculation gives the investor the greater number of shares.

2. Maturity Date

The SAFE may also include a “Maturity Date” conversion event, which is a sunset date for converting the SAFE to shares if another conversion event has not occurred before then. Again, the relevant question is how the number of shares is to be calculated. This could be by reference to the valuation cap, although investors may object that if the company has not conducted a priced equity round before the Maturity Date then the valuation cap may be overly generous to the company. Another option is to agree a mechanism for the parties to negotiate the conversion price at the time, with a third party valuer to make a determination if the parties cannot agree.

3. Pre-emption Rights

Investors sometimes seek to include in SAFEs a pro-rata right to participate in the company’s next priced equity round. Companies must ensure that any SAFE pre-emption rights are consistent with pre-emption rights held by the company’s shareholders in its shareholders’ agreement, and with pre-emption rights in other SAFEs. If the company has not adopted a shareholders’ agreement at the time the parties enter into a SAFE, the SAFE should still anticipate this issue to avoid a situation where the company cannot comply with pre-emption rights held by one group, such as shareholders, without defaulting on pre-emption rights held by another group, such as SAFE holders.

4. Shareholders’ Agreement

One advantage of a SAFE is that it is not necessary for the company and the SAFE investors to negotiate a shareholders’ agreement. However, the parties would be unwise to ignore the shareholders agreement altogether. For the company it is important that the SAFE obliges investors to accede to the company’s shareholders’ agreement as a condition of being issued shares by the company upon conversion of their SAFEs, even if the company does not have a shareholders’ agreement in place at the time that the parties enter into the SAFE. In effect the investor is being asked to agree to a document that it has not reviewed and in fact does not exist. This can be a point of contention, although it can be overcome without resorting to negotiating a long form shareholders agreement at the outset. For example, for the investor it may be sufficient if the SAFE instrument includes certain ‘redlines’ to which the investor will not agree to be bound to in the shareholders agreement.

5. Fully diluted share capital

Finally, companies should be cognisant that, if they are issuing more than one tranche of SAFEs, or SAFEs and convertible notes, on materially different terms, there are no unforeseen complications in calculating the number of shares to be issued to each investor holding a SAFE or convertible note on a conversion event. In particular, if the relevant formula involves determining the company’s fully diluted share capital, other SAFEs and convertible notes should be expressly excluded from the company’s fully diluted share capital, or the way in which each instrument converts relative to the others will need to be carefully considered, to avoid circular calculations.

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