A Simple Agreement for Future Equity (SAFE) is a financing contract used by start-ups and investors where operating capital is exchanged for the right to acquire equity at a future time or event, such as the closing of an equity financing round, an M&A transaction or an IPO/ reverse takeover. A SAFE differs from a convertible loan because it is not a debt instrument and it is considered a “convertible equity.”[1]
Benefits of SAFEs include execution in a short period of time and relatively lower legal costs due to the simplicity of the agreement itself. Potential Investors may prefer a SAFE because in the event of a dissolution, the agreement may contain a clause which gives the investor priority over common shareholders. However, the investor will not have security rights over the assets of the company and other creditors may have priority. [2]
Introduction
The Y Combinator Accelerator in Silicon Valley first introduced the SAFE in late 2013 due to the relatively high volume of early stage deals. A SAFE was simple and effective method of financing to get the initial capital of a company. According to Y Combinator:
The [SAFE] has what we think is a huge advantage for both founders and investors – the ability to calculate immediately and precisely how much ownership of the company has been sold. It’s critically important for founders to understand how much dilution is caused by each safe they sell, just as it is fair for investors to know how much ownership of the company they have purchased.[3]
In early 2017, the National Angel Capital Organization (NACO) created a task force of members and stakeholders, including the Federal government, RBC and large law firms, to bring legally compliant and nationally accepted best practices of SAFEs to the Canadian market. The task forced published the Educational Notes to the Simple Agreement for Future Equity (SAFE) (NACO Guidelines) which highly Canadian nuances to the financing contract.
The Canadian Simple Agreement for Future Equity (Canadian SAFE) is modelled after the Y Combinator SAFE. According to NACO, pros of the Canadian SAFE include:
- It is a simple and fast agreement, a figurative ‘papered handshake’
- It favours the company much like a convertible loan can
- It works best in a hot/active market with promising start-ups
- It can assist with obtaining a tax credit in certain provinces
Conversely, the negatives of the Canadian SAFE include:
- It is an open-ended deal and the investor can be left ‘hanging’
- Can be used inappropriately, if the founder is not properly knowledgeable on the structure
- Some formats may not work in Canada[4]
Important elements of both the Canadian SAFE and the Y Combinator SAFE is the inclusion of a triggering event, valuation cap and a discount. A maturity date was added to the Canadian SAFE to make it more appropriate for the Canadian market. The definition of terms and discussion of sections in the Canadian SAFE will be discussed in the next paragraph.
The Important Terms and Features of a Canadian SAFE
Triggering Event
A SAFE is based on an anticipated event in the future as opposed to a strict date (a Canadian SAFE may still need a maturity date to be effective). Once this event occurs, the right to receive equity by the investor will convert to actual equity, often preferred shares. A common event for conversion is future equity financing, usually led by an institutional venture capital (VC) fund. However, there are other events which may trigger the conversion, such as a change of control scenario, an IPO or liquidation.
If a liquidity event occurs, under the NACO Guidelines, there are two options available to the investor. The first option is to receive a cash payment equal to the purchase amount, or second, automatically receive from the corporation a number of shares equal to the purchase amount divided by the liquidity price. Both a merger or acquisition, and an IPO qualify as a liquidity event.[5]
Equity Financing
In general, the purpose of investing through a SAFE is to capitalize on a future equity financing event. The conversion from a right to equity is governed by a specific formula based on the terms of the SAFE. Importantly, many SAFEs do not to include a minimum amount for future equity financing event and may convert based on the valuation of the financing event
If there is an equity financing event before the maturity or termination of the SAFE, the company will automatically issue to the investor either:
- a number of shares sold in the equity financing equal to the purchase amount divided by the price per share of the shares, if the pre-money valuation is less than or equal to the valuation cap; or,
- a number of shares equal to the purchase amount divided by the SAFE price (valuation cap divided by total outstanding shares, less the discount), if the pre-money valuation is greater than the valuation cap.[6]
The first equity financing event may be in common or preferred shares. In the US, it is commonly in preferred shares. On the triggering of the conversion of the SAFE, the investor will become a shareholder and his or her name will show in the share register.
Dissolution Event
If a dissolution event of the company occurs before the SAFE matures, the company will be liable to pay the investor the purchase amount. The purchase amount should be paid before any distribution to common shareholders of the company. Under the NACO Guidelines, if the assets of the company are insufficient to permit the payment then the entire assets of the company available for distribution will be distributed with equal priority and pro rata among the investors. In practical reality, it is questionable if there would be any funds left to distribute to investors as they will rank behind the government, employees and trade creditors.[7]
Valuation Cap
The valuation cap is an optional term which protects the investor from dilution of their shares. It will generally be the main basis of negotiation between the investor and company. The valuation cap of a SAFE sets a contractual ceiling on the pre-money valuation that will be used to calculate the price at which an investor’s SAFE converts to equity at the time of a future conversion event. The valuation cap entitles investors to convert into equity at the lower of the valuation cap or the price in the subsequent financing.[8]
Essentially, the valuation cap ensures the initial SAFE investor gets a better price per share than a later investor. If in a subsequent equity financing round, the company is able to raise more money than the valuation cap, the investor benefits because it receives equity based on the lower valuation cap, thus receiving more shares. If less money than the valuation cap is raised, the investor still benefits because it can select the lower amount as the basis for the equity financing calculation.
Discount Rate
The discount rate is another optional term which benefits the investor. It is an incentive for the investor for participating in a convertible equity structure. It is specifically defined amount which is a discount to the share price at which the SAFE converts. The NACO Guidelines suggest that this often ranges from 15 to 30%, however, founders should negotiation in the best interest of the company. As a general rule, the shorter the term and the less risky the investment, the lower the expected discount.[9]
Maturity Date
The maturity date is an inclusion in Canadian SAFE and is not included in its US counterpart. Based on the construction of a SAFE, it could be outstanding for a relatively long period of time, as the it will expire only when the investor receives equity or cash. To improve investor protection in the Canadian market, NACO suggests a specific maturity date.
Conclusion
Thus, a SAFE has three main forms:
- SAFE with a valuation cap, no discount
- SAFE with discount, no valuation cap
- SAFE with valuation cap and discount
If you are interested in using SAFEs, it important to plan your financing cycle with the founders based on the business plan and growth valuation. Understanding the long-term cash needs of your business will help you execute effective SAFE which benefit both the company and the investors.
For more information, please call Barbara Hendrickson (416) 601-1004 or Ray Luckiram (416) 601-0591 at BAX Securities Law.
This publication is not intended to constitute legal advice. No one should act on it or refrain from acting on it without consulting with a lawyer. BAX does not warrant or guarantee the accuracy or currency or completeness of the publication. No part of this publication may be reproduced without the prior written permission of BAX Securities Law.
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[1] Educational Notes to the Simple Agreement for Future Equity (SAFE), National Angel Capital Organization (NACO), April 2017.
[2] C. Levy, Safe Financing Documents, Y Combinator, September 2018, available at https://www.ycombinator.com/documents/#about
[3] NACO, supra note 1.
[4] Common Docs, NACO, accessed on May 12, 2019, available at https://www.nacocanada.com/cpages/common-docs
[5] NACO, supra note 1.
[6] NACO, supra note 1.
[7] NACO, supra note 1.
[8] NACO, supra note 1.
[9] NACO, supra note 1.
