Without sufficient funding, startups can be hard to get off the ground. From family and government programs to accelerators and bank loans, entrepreneurs seek out financial help where they can. As an entrepreneur, you have no doubt been thinking about raising pre-seed funding, seed funding, and Series A funding rounds. There is, however, also another additional tool for financing you may want to consider known as a Simple Agreement for Future Equity agreement, or SAFE Agreement.
What is a SAFE (Simple Agreement for Future Equity) Agreement?
A SAFE agreement is a financial contract that is drawn up between startups and investors. Developed in 2013 by YCombinator, an accelerator in the United States, the SAFE agreement was created as a way to streamline the early-stage seed funding process of budding startups. It provided an efficient and far more simpler way to generate financing than traditional convertible loans.
How Does a SAFE Agreement Work?
SAFE agreements are a way for founders to raise money by selling investors the right to convert the capital agreed to in the SAFE into shares later on when a predetermined (triggering) event occurs.
A few added characteristics makes a SAFE agreement an appealing method of financing. First, there are no interest rates or maturity dates with a SAFE agreement, which means less negotiation is needed. Both parties would only have to discuss the valuation discount and valuation cap, making it more effective to deal with when it comes to paperwork and negotiation. In addition, a SAFE Agreement offers room for a side letter option, allowing investors to get pro-rata rights in future financing. Lastly, a SAFE can be finalized when both parties are ready to sign and transfer funds rather than having to traditionally wait to finalize numerous investors at once.
Canadian SAFE Agreements
Because the YCombinator SAFE agreements proved to be effective, more and more startups in Canada were also wanting to take advantage of its benefits. Since 2017, the National Angel Capital Organization (NACO) has worked with other organizations, including the Federal government, to ensure that the Canadian Simple Agreement for Future Equity (Canadian SAFE) has been adapted to work with Canadian securities laws.
Canadian SAFE Agreements: Advantages and Disadvantages
Advantages of the Canadian SAFE agreement:
- Simple and easy to draft
- It can be executed quickly
- It requires lower legal costs to process
- It is deal in a startup market
- The agreement may give investors priority over common shareholders
- There are tax credits for SAFEs provided by some provinces
- There is more transparency with regards to what each party is giving and receiving
Disadvantages of the Canadian SAFE agreement:
- It is an open-ended deal – triggering events may not occur
- Some SAFE agreement formats may not work in Canada
- SAFE agreements are not that well-known in Canada
- More dilution than expected could occur
- Investors will not have rights over assets
What is in a Canadian SAFE Agreement?
While the Canadian and YCombinator SAFE agreements include similar terms and features such as a triggering event, valuation cap and discount, a maturity date is also added to the SAFE agreement Canada version to adapt it for the Canadian market.
A triggering event is defined in the SAFE Agreement. It is the point at which the SAFE holder becomes a shareholder of the company. The usual trigger for converting a SAFE is an equity financing or liquidity event.
If it is an equity financing event, the SAFE holder will be able to convert the SAFE into equity at a predetermined price. If the triggering event is a liquidity event, the investor will either receive a payment equal to the purchased value of the SAFE or the startup will issue shares that are equal to the SAFE purchase price divided by a liquidity price that was also predefined in the SAFE.
The valuation cap determines the upper limit on the company’s valuation. This is set when calculating the price at which the SAFE purchase amount will be converted into company equity. The valuation cap ensures that the SAFE holder receives a lower price per share than later-stage investors.
Should a dissolution of the company occur and it needs to liquidate its assets, creditors will be given priority and be paid first. SAFE investors do not have rights over the assets of the company, but they will be paid the purchase amount they were guaranteed by the company before common shareholders are paid.
This is a discount to the price per share outlined by the SAFE which will be issued by the company to SAFE holders during an equity financing event. It becomes an incentive for investors to enter into a SAFE agreement. This is because purchasing the SAFE at earlier stages locks investors in to convert their SAFE at a lower price during an equity financing trigger event. Under NACO’s suggestion, the discount rate should range between 15% to 30% lower than what other later investors are offered.
What Types of SAFE Agreements are there?
The above terms and features can be emphasized in different ways. This way startups and investors can tailor a SAFE agreement template they can both work with. You can have different types of SAFE agreements.
You can have:
- SAFE with a valuation cap, no discount
- SAFE with discount, no valuation cap
- SAFE with a valuation cap and discount
What should be Considered when looking at a SAFE Agreement?
If you are considering investing in a SAFE or offering one to potential investors, you will want to ensure that you have a firm grasp on not only what goes into one, but the possible issues when implementing or participating in one.
For instance, if you are an investor who is considering participating in a SAFE agreement, you will want to consider a few aspects that will help prevent the amount of risk you will take on:
Granting of Information Rights
When you participate in a SAFE agreement, the startup will be at an early stage of development and you will have minimal information about the company. The Company should provide you with some basic rights to information. NACO has outlined some basic information rights for SAFE investors, such as those for periodic financial statements, an annual budget and updates.
The province by which a SAFE agreement is governed is important. For instance, if the SAFE is being issued under the laws of Ontario, it should also be subjected to the provincial and securities laws of Ontario. This ensures that any resulting equity will be subject to any tax credits and hold periods under the laws of Ontario.
You may want to discuss having a Termination Date in the SAFE agreement. A termination date will give you some reassurance that the company will use the timeline to work and develop towards the triggering event. It will also help prevent your investment from potential dilution before you hit the triggering event.
If you are a startup looking to implement a SAFE agreement, you should carefully consider the state and plan of your company’s development to ensure that your SAFE agreement is reasonable and appealing:
When working with investors to raise capital, you should have financial statement projections for the next 12 to 18 months ready to present. Because SAFE investors are counting on your company’s potential, you need to convince them with a solid business plan outlining the company roadmap and intended use of proceeds for the SAFE financing.
Investors that are seriously considering funding your startup will take a hard look at your company’s financial health. Questions they may ask when evaluating the SAFE agreement:
- Does the company have any debt?
- What is the company’s current cash position vs the company’s cash burn rate?
- What kind of financing has already been completed?
- Is the Company a party to any convertible loans from related parties or third parties?
- Does the Company have plans to conduct one or more financing rounds?
Questions like these have the potential to impact the SAFE agreement, the resulting equity, and the investor’s belief in your company’s success and ability to grow. Consult with a financial lawyer to better understand the financial dynamics of your startup with regards to a SAFE agreement,
If there will be a shareholders agreement, carefully consider any clauses that can negatively affect the conversion of the SAFE into equity. You want to ensure that you can uphold the SAFE agreement terms without issue.
As mentioned above, SAFE agreements are relatively new to Canada, and as such, people looking to establish a Canadian startup and even some investors may not be familiar with them. If you need help with one, the Toronto corporate lawyers at OMQ Law can help you review a SAFE agreement and explain the terms within it. Call OMQ Law for a free consultation.