Safe Investment Instruments: Where To Put Your Money

When it comes to investing, there are a variety of instruments available, each with its own unique characteristics and risk profile. One such instrument is the SAFE, or Simple Agreement for Future Equity. SAFEs are agreements between investors and companies that provide investors with rights to future equity in the company, similar to warrants, but without specifying a price per share at the time of the initial investment. SAFEs are designed to be a simpler mechanism for startups to secure early-stage funding, and they have become increasingly popular due to their flexibility and founder-friendly nature. However, it's important to note that SAFEs may come with potential drawbacks, such as the time it takes to convert them into equity and the lack of interest earned. Understanding the characteristics and risks associated with different investment instruments is crucial for making informed investment decisions.

Characteristics of a Safe Investment Instrument

What is a SAFE?

SAFE, an acronym for Simple Agreement for Future Equity, is an investment instrument and contract that gives an investor the right to convert their SAFE into equity at the company's next equity financing round or liquidation event. SAFEs are usually deployed by startup companies to raise capital in their seed financing rounds. They are also used by investors who are interested in more than just getting paid back. The high risk associated with a startup is accompanied by the potential for high upside. As such, investors want their SAFE to "convert" into equity at a later stage.

SAFEs are different from convertible notes in that they are not a debt instrument and are usually simpler and shorter. They do not have a maturity date, interest accrual, or a specific price per share at the time of the initial investment. SAFEs are intended to provide a simpler mechanism for startups to seek initial funding other than convertible notes. The precise conditions of a SAFE vary, however, the basic mechanics are that the investor provides funding to the company in exchange for stock in the company at a later date, in connection with specific, contractually agreed-upon liquidity events.

SAFEs carry potential drawbacks. Investors may have to wait a long time to convert their SAFE into equity, may not get the best deal, and will not earn interest. SAFEs are also dangerous for non-accredited crowdfunding investors who might be directed towards SAFEs in small businesses that will never obtain priced equity financing. Additionally, the tax treatment of SAFEs is disadvantageous, as the holding period begins upon stock issuance rather than the signature of the SAFE.

The SAFE was created by the team at Y Combinator and has been a popular method for investing in the earlier stages of a company.

How does a SAFE work?

SAFE stands for Simple Agreement for Future Equity. It is a financing contract that may be used by a startup company to raise capital in its seed financing rounds. SAFEs are different from convertible notes in that they are not a debt instrument and are usually simpler and shorter. They are also more founder-friendly. SAFEs do not have a maturity date and contain provisions for early exit, dissolution of the company, discounts, and valuation caps. They do not accrue interest.

When investors invest in a SAFE, the SAFE's terms give them the right to convert their SAFE into equity at the company's next equity financing round or liquidation event. The precise conditions of a SAFE vary, but the basic mechanics are that the investor provides funding to the company at signing. In return, the investor receives stock in the company at a later date, in connection with specific, contractually agreed-upon liquidity events. The primary trigger is generally the sale of preferred shares by the company, typically as part of a future priced fundraising round.

The SAFE investor receives the future shares when a priced round of investment or liquidity event occurs. The price of the equity that the SAFE holders receive on conversion is lower than the price of the securities issued to VC investors in connection with a Next Equity Financing, based on either a discount rate or a valuation cap. SAFEs may have similar conversion features but lack the debt hallmarks of convertible notes.

There are potential drawbacks to investing via SAFEs. Investors may have to wait a long time to convert their SAFE into equity. Without a maturity date and no pressure on the company to progress toward a priced equity round, investors may be waiting a long time for a conversion. Additionally, investors may not get the best deal. If the SAFE only has a valuation cap and no discount rate, upon conversion, the investor may get no better terms than later investors.

Pros and cons of a SAFE

A SAFE (Simple Agreement for Future Equity) is a legal contract between a startup and an investor that allows the investor to purchase equity in the company at a future date. SAFEs are typically used by early-stage startups to raise capital.

Pros

• Simplicity and speed: SAFEs are generally simpler and faster to execute compared to convertible notes, with fewer terms and conditions. This makes the fundraising process faster and more streamlined.
• No interest or maturity date: SAFEs do not accrue interest or have a maturity date, which makes them more appealing for startups that want to avoid debt or immediate shareholder obligations.
• Flexibility: SAFEs are designed to be flexible and easy to customize to the specific needs of the startup and the investor. This can make the investment process simpler and faster when compared to traditional equity financing.
• No debt: SAFEs are not considered debt instruments, which means they do not come with interest rates or maturity dates. This also removes the obligation for the company to repay the investment with interest.
• No valuation required: SAFEs do not require a valuation of the company at the time of investment, which is advantageous for early-stage startups that may not have a clear valuation yet.

Cons

• Dilution risk: Since SAFE investments convert into equity at a future date, existing equity holders may face dilution of their ownership percentage in the company.
• Uncertainty of conversion: The timing and conditions of conversion of a SAFE investment into equity are often unknown, and investors may not have a clear understanding of when and how their investment will convert.
• Potential for a better deal later: If you invest in a SAFE with only a valuation cap and no discount rate, you may find that upon conversion, you get no better terms than later investors.
• Long wait times: SAFEs typically don't have a maturity date, so investors may have to wait a long time for the company to progress toward a priced equity round, leading to a long wait for conversion.
• Tax treatment: The holding period for Qualified Small Business Stock tax exemption begins upon stock issuance rather than the signature of the SAFE, which can be disadvantageous for investors.
• Voting control: There is a risk of unexpected dilution and voting control issues, especially when multiple SAFE investment rounds are done prior to a priced equity round.

How is a SAFE different from a convertible note?

A Simple Agreement for Future Equity (SAFE) is an agreement between an investor and a company that provides rights to the investor for future equity in the company, similar to a warrant. The SAFE investor receives the future shares when a priced round of investment or liquidity event occurs. SAFEs are not debt instruments and do not have interest rates or maturity dates. They are also usually simpler and shorter.

A convertible note, on the other hand, is a debt instrument that can convert into equity upon a future qualifying event or transaction, such as a priced equity round raised from venture capital investors. It is a short-term loan to startups that mature into equity over time. Convertible notes have interest rates and maturity dates (when the note expires). If the note hasn't already been converted into equity by the maturity date, the company typically is required to repay the noteholder's principal investment plus interest.

The primary difference between the two is that SAFE notes prescribe a specific conversion method while convertible notes offer varying conversion terms. SAFE notes convert into the next round of preferred stock that the company issues in the subsequent priced financing round. In contrast, convertible notes have specific thresholds for triggering conversions.

Another difference is that SAFEs are more popular in startup environments due to their simplified and streamlined fundraising process. They are also more founder-friendly. However, as use has become more prevalent, concerns have emerged related to unexpected dilution and voting control issues for entrepreneurs, especially when multiple SAFE investment rounds are done prior to a priced equity round.

When deciding between a SAFE and a convertible note, it is important to consider the investors, the amount of money to be raised, and the willingness to wait for a conversion event and forgo interest payments.

What are the tax implications of a SAFE?

A Simple Agreement for Future Equity (SAFE) is a financing contract that may be used by a startup company to raise capital in its seed financing rounds. It is an investment contract between a startup and an investor that gives the investor the right to receive equity in the company on certain triggering events, such as a future equity financing round or the sale of the company.

SAFEs are considered prepaid equity instruments for tax purposes. They can be treated as forward contracts, where investors pay now for a future right to receive shares when a transaction occurs, such as a qualified financing or liquidity event. The number of shares received depends on the company's valuation at that time.

While SAFEs are generally not treated as debt for tax purposes due to the absence of debt characteristics such as maturity dates, interest rates, and repayment terms, the correct tax treatment can be complex and may depend on various factors. These factors include the presence of a fixed maturity date, interest payments, the right to enforce payment, and the relationship between stock holdings and the instrument in question.

The tax implications of SAFEs can impact both the company and the investor. For example, upon conversion to equity, the company may recognize a taxable gain or loss, while the investor must recognize interest income. Additionally, companies that issue SAFEs are responsible for reporting transaction details and the resulting tax liability to relevant tax authorities, and neglecting tax compliance can lead to issues and potential penalties.

It is recommended to consult a tax professional or financial advisor for precise guidance on the tax implications of SAFEs, as tax laws and regulations can change, and specific circumstances may affect the tax treatment.

Frequently asked questions