If you are like most bootstrapping startup founders, you are always on the lookout for quality free resources. In the legal space, these can be hard to come by. This is not because law firms are unwilling to share their intellectual capital – as you will find on our blog and elsewhere, there is a wealth of free information available – but, when it comes to legal documents, there simply is no one-size-fits-all approach that will work for start-ups in different scenarios.
Consider, for example, the simple agreement for future equity (SAFE) available from the Y Combinator (YC). The SAFE is actually four different agreements designed for use in different scenarios; and, in the words of the YC:
“[A] safe may not be suitable for all situations, the terms are intended to be fairly neutral. So while we would, of course, advise both parties using a safe to have their lawyers look at them, we believe a safe provides a starting point that we hope can be used in many situations without too many modifications. Needless to say, YC does not assume any responsibility for any consequence of using a safe or any other document found on our website.”
To recap, the SAFE is “a starting point” that they “hope” can be used “without too many modifications.” So, if you are thinking about using a SAFE, what do you need to know in order to make sure that your rights as a company founder are secure?
Start-Up SAFE Equity Investment Contract Q&A
Q: What is a SAFE?
First, let’s start with a simple question: What exactly is a SAFE?
The SAFE is a form agreement for use by startup founders seeking outside funding without using debt and without getting into the complexities of convertible notes and other more traditional, more complicated, and potentially less favorable investment vehicles. With a SAFE, the investor puts cash into the company up front, and then receives a stake in the company on the back end upon the occurrence of a triggering event or the satisfaction of certain specified conditions.
Q: Why should startup founders consider using a SAFE?
One of the primary benefits of the SAFE structure is that it does not involve debt financing. While this is certainly not unique to the SAFE contracts, it is one benefit to consider among various (potential) others offered by the SAFE. As outlined in YC’s SAFE Primer, other potential benefits of using a SAFE include:
- Avoiding the regulatory, insolvency, and other risks associated with various alternate forms of financing;
- Limiting the amount of negotiation required in order to secure funding; and,
- Relying on an equity structure that “has the potential to become standardized,” which could eventually mean enhanced certainty and efficiency in the fundraising process.
Q: Why would investors agree to sign a SAFE?
In a word, simplicity. If an investor is willing to put down money for an equity investment, the SAFE contracts are designed to make the investment process as simple and straightforward as possible. With the four different forms that are available (and, of course, the ability to modify any SAFE to suit the parties’ unique requirements), the SAFE contracts offer a potentially attractive blend of standardization and flexibility.
Q: What are the different forms of SAFE contracts?
The Y Combinator has published four different forms of the SAFE – a “standard” version and three alternative versions:
- Valuation Cap Only – This is the “standard” version of the SAFE. It provides that, if there is a future round of equity financing after the agreement is executed, the investor will be entitled to a number of shares to be determined based upon whether the pre-money valuation for the financing is above or below the “Valuation Cap” negotiated by the parties.
- Cap and Discount – This version is similar to the cap-only version, but also includes a negotiated “Discount Rate” which can be used as an alternative for converting the SAFE into company equity.
- Discount, No Cap – This version includes only the negotiated Discount Rate, doing away with the option for the value investor’s equity rights to be directly conditioned upon the company’s pre-money valuation.
- Most Favored Nation (MFN) – The MFN version of the SAFE provides that the agreement can be amended to reflect the terms of subsequently-issued SAFES if those terms are more favorable to the investor. In the event of a non-SAFE equity investment prior to the exercise of the MFN provision, the SAFE investor, “would receive the same shares of preferred stock as the investors of new money . . . at the same price.”
Q: What are some of the key SAFE provisions for startup founders?
Setting aside the equity vesting terms that vary from one form of the SAFE to the next, some of the key terms for startup founders include the following. This summary is based on the terms of the “standard” Valuation Cap Only form of the agreement:
1.(c) Dissolution Event
What happens if the company goes out of business before a SAFE investor gets his, her, or its money back? Under the standard safe agreement, the investor is entitled to full repayment before any distributions are made to the company’s founders. If there is not enough liquidity to pay all SAFE investors, then each is entitled to a pro rata distribution and the founders leave with nothing.
3.(b) Company Authorization
When entering into a standard SAFE, the start-up must represent that the SAFE is both (i) authorized under the company’s governing documents, and (ii) not inconsistent with any pre-existing obligations of the company. In other words, the start-up’s founding documents must include the necessary provisions for accepting SAFE investments (which may require amendments or formal resolutions), and entering into the SAFE must not interfere with the rights of any pre-existing investors.
3.(e) Intellectual Property Rights
Under the SAFE, start-ups must also represent that they, “own or possess (or can obtain on commercially reasonable terms) sufficient legal rights to all patents, trademarks, service marks, trade names, copyrights, trade secrets, licenses, information, processes and other intellectual property rights necessary” to the current and proposed operation of the business. Any infringement risk is a deal-breaker under the SAFE, as is generally the case with other forms of investment and full company sales.
5.(c) Limited Investor Rights
SAFE investors are not entitled to receive dividends or otherwise participate in the benefits of company owners (until they receive their shares, and then only subject to the terms of the company’s shareholder or membership agreement). In addition, SAFE investors do not receive, “any right to vote for the election of directors or upon any matter submitted to stockholders at any meeting thereof, or to give or withhold consent to any corporate action or to receive notice of meetings.”
5.(d) Restriction on Investor Assignment
SAFE investors cannot assign their rights under the agreement except to an entity or individual which shares common ownership or control rights. This ensures that founders retain a reasonable amount of control over who invests in their companies, and that they cannot be backed into having competitors or others with adverse interests as investors.
Considering a SAFE Investment? Speak with a Start-Up Lawyer in Confidence
If you are considering using a SAFE contract for outside investment in your start-up, or if you have questions about the alternative investment options that are available, we encourage you to contact us for a confidential consultation. To speak with a start-up lawyer at Jiah Kim & Associates, please call (646) 389-5065 or schedule an appointment online today.
This blog post is written for educational and general information purposes only, and does not constitute specific legal advice. You understand that there is no attorney-client relationship between you and the blog publisher. This blog should not be used as a substitute for competent legal advice from a licensed professional attorney in your state.