In 2013, the influential, Seed Fund and Startup Accelerator, introduced a new form of funding document that would expedite early seed funding between investor and company with five-page SAFE Documents. SAFE = (Simple Agreement for Future Equity).
This document is favored by companies and many investors because it’s simpler than a convertible note, and comes with provisions that protect the founders. A SAFE is convertible equity that converts at a “liquidity point,” (when a company starts raising for equity financing, receives stocks, and is sold), and requires negotiation on only one point: the valuation cap.
But is this type of simplification truly beneficial for all parties involved? How have investors warmed to this new type of funding that protects companies when they are at their riskiest? Here are some drawbacks worthy of your consideration when using SAFE documents — from an investor point of view.
Doesn’t accrue interest.
One major concern investors have about SAFE documents over convertible notes is that SAFE documents are not debt instruments and therefore do not accrue interest. For many investors, this interest is a nominal figure, but a 6 percent interest rate for a convertible note worth $100,000 over the course of 18 months is not insignificant, and can also convert to more equity on top of the invested principal.
Does not have a maturation date.
A SAFE document is supposed to convert when the SAFE holder starts raising for equity financing, receives stocks or cash, upon sale of the company, an IPO or a dissolution (in which case, money would be first distributed to SAFE investors before anyone else). However, there is no official maturation date for the document. If a company does well enough to survive on its own without requiring further rounds of funding or equity financing, the SAFE document can be held indefinitely, with almost no provisions that justify a repayment.
SAFE requires a company to be incorporated (not an LLC).
For all of SAFE’s benefits to founders when it comes to simplifying the process, it might still require some legal fees for most unincorporated startups, which account for many new companies. Since the value of a SAFE document has to be reflected on the capitalization table (as it is considered an outside investment), a company needs to be considered a C-Corp in order to receive a SAFE document, as opposed to an LLC.
In order for a founder to receive a SAFE document, they will need to consult a lawyer and think over their tax structure (including being taxed twice, as they will no longer be able to combine their business income taxes with personal income taxes), before signing a SAFE document. While this doesn’t affect the investor as much, it still requires a delay and a probably higher investment.
Less experience using a SAFE, not common outside of YC.
As most founders who prefer SAFE documents are alumni of Y Combinator, there’s still very limited use of SAFE documents within Silicon Valley and LA, and very little traction outside of those cities. As a result, many investors who haven’t recently been in negotiations with YC companies will not have had many (or any) opportunity to file a SAFE document, and may be skeptical. It is still not considered standard issue financing yet.
All risk, no reward — early stage risk, waiting indefinitely for, “Liquidity Event.”
Investors often see SAFE documents as taking all the risk, with few of the rewards. The younger the company is, the more risk is involved in funding them. Convertible note holders have the incentive to loan money to new companies because they can accrue interest, and convert to equity with a discount, as well as a valuation cap on when the note can convert.
However, SAFE holders have few of these rights or incentives to take on a company at their riskiest stage. In the event of a company insolvency, a SAFE holder, as neither a creditor nor an equity holder, so it has few fiduciary duties surrounding the fate of the company, and they have no legal claim to a startup’s assets (depending on the provisions placed on the SAFE).
From the outset, there are many reasons to adopt the SAFE into everyday investments: it’s low-risk, pro-company, easy to sign, and easy to cash out. Upon closer look, SAFE’s may work at a disadvantage to investors. However, at the end of the day, an investor has to have the best interests of the company in mind, and to foster them without sneaky provisions, so the company can blossom and reach its highest potential. In this way, being pro-company is pro-investors.
To decide whether or not a SAFE document is best for your current investment, you may want to consider the relationship between you and the company, and who needs more protection.
