SAFE financing method for startups

Author: Attorney Jin Jianzhi

Web3.0 entrepreneurs have often heard of SAFT (Simple Agreement for Future Token) and SAFE (Simple Agreement for Future Equity). They all know that SAFT and SAFE are simple, flexible and efficient financing methods, and they only have a few pages. SAFT is used to raise token rights, and SAFE is used to raise equity.

For entrepreneurs who do not have financing needs, the above-mentioned knowledge about SAFT and SAFE is enough, but for entrepreneurs who really need financing, these are not enough. When a company is in the early stage and does not yet have a clear business model, profitability or asset base, traditional equity financing may not be applicable, but entrepreneurs really need funds to promote product development, marketing and business development. In this case, entrepreneurs can use SAFE as a fast and simple financing tool to raise funds by selling future equity. This time, I will share with you more knowledge about SAFE so that entrepreneurs can make more suitable choices in early financing.

01 SAFE Background

The world facing capital is changing rapidly. The rapid development of the Internet and high-tech has made low-cost and high-return investments seem to be within reach. Faced with new market opportunities, venture capital came into being. The characteristic of venture capital is the preference for high returns, which makes its tolerance for risks higher.

Faced with the investment needs of venture capital for start-ups, especially in the early stages of seed rounds and pre-seed rounds, Silicon Valley investors and lawyers created some common documents to reduce the financing costs of both parties in the seed round. Among them, the following four are relatively well-known: TechStars Series AA Model Seed Financing Documents (by Cooley), Founders Institute Plain Preferred Term Sheet (by WSGR), Series Seed Financing Documents (these forms are not publicly available); Y-Combinator Series AA Equity Financing Documents.

But obviously, these general documents are not simplified enough. In order to further speed up the process of seed and angel investment, help startups and investors save legal fees, and reduce the discussion time for negotiating investment terms, Y-Combinator iterated its Y-Combinator Series AA Equity Financing Documents, and SAFE was born. Since the SAFE agreement itself is simple, the time from determining investor intentions to completing financing is short, and it is relatively fair to both investors and financiers, Web3.0 startups often use the SAFE agreement to conduct early financing.

02 The difference between SAFE and equity financing

SAFE is not the same as real equity financing. For entrepreneurs of start-ups, the following two points are the main differences that need to be understood:

Valuation and pricing:

SAFE: Usually does not involve the determination of the valuation of start-ups. When investors and start-ups reach an agreement, there is no need to negotiate on valuation. Start-ups and investors only need to focus the negotiation on the future valuation cap.

Equity financing: involves the determination of company valuation. Investors and companies need to negotiate on the company's valuation and stock price, and finally determine the purchase price of equity.

Investor Rights:

SAFE: Legal nature is neither equity nor debt. It only promises to convert investment into equity, cash or other income when equity financing (or other events) occurs in the future. Therefore, SAFE investors can only enjoy shareholder rights after the start-up has equity financing in the future. Before a specific event occurs, SAFE investors can neither ask for repayment and interest, nor have any shareholder rights, and cannot participate in company management and enjoy company dividends.

Equity financing: directly purchase shares from the company. After the financing is completed, the investor becomes a shareholder of the company and enjoys the relevant rights of shareholders.

03 What are the terms that need to be paid attention to in SAFE?

SAFE is quite different from traditional investment and financing documents. Here are 2 key terms.

1. What is the difference between SAFE preferred stock and standard preferred stock?

Standard preferred stock is preferred stock issued to new investors in equity financing. SAFE preferred stock is issued in equity financing as a series of independent preferred stocks. SAFE preferred stock has the same rights and restrictions as standard preferred stock, but the liquidation amount, initial conversion price and dividend amount are calculated based on the per share price of standard preferred stock (which is determined by dividing the post-investment valuation cap by "company capital"). For example, if the company is conducting a Series A financing and issuing Series A-1 preferred stock to new investors, then SAFE holders will be issued Series A-2 preferred stock. The only difference between A-1 preferred stock and A-2 preferred stock is the name, price per share, liquidation amount per share (but not liquidation preference or multiples), initial conversion price and dividend amount per share (but not dividend rate). 2. What if the Pre-Money Valuation in the Equity Financing is higher than the SAFE’s Post-Money Valuation Cap? SAFE holders’ ownership will be determined by the greater of: (1) the Post-Money Valuation Cap amount, or (2) the SAFE’s original investment amount, the number of shares purchased. In most cases, if the company’s Pre-Money Valuation in the Equity Financing is higher than the Post-Money Valuation Cap, then the Post-Money Valuation Cap will apply. In this case, SAFE holders will be issued SAFE Preferred Stock at a liquidation amount equal to the purchase amount. This means that the liquidation amount to the SAFE holder will not exceed the SAFE’s original purchase amount. In some cases, if the Post-Money Valuation Cap and the Pre-Money Valuation in the Equity Financing are close, then SAFE holders will actually receive more shares, calculated at the price per share paid by the new money investors. In these cases, SAFE holders will receive shares of Standard Preferred Stock at the same price per share paid by the new money investors.

04 How to use SAFE?

SAFE’s characteristics of “neither equity nor debt” and “investment can only be converted into equity, cash or other income when a specific event occurs” have screened the profile of investors—pursuing high returns, having a high tolerance before a specific event occurs, and being non-traditional. Some start-ups may find it difficult to raise further funds during their development. In this case, the rights held by SAFE investors will hardly have room for growth. Investors can only withdraw their investment principal, and the purpose of investment income is also difficult to achieve.

When funds are tight in the market, sometimes it is not the investors who are chasing after start-ups, and the standard SAFE agreement cannot be “one fits all”. When all parties have their own special needs, the SAFE agreement still needs to be reviewed and approved by lawyers.

At the same time, start-ups should always pay attention to the following two points when using SAFE:

1. Signing a SAFE agreement requires the approval of the company's internal resolution board of directors or shareholders meeting;

2. Carefully consider whether to introduce pro rata rights and how to allocate them if introduced, otherwise it will lead to excessive dilution of the founding team's shares.