By Nicole Hatcher and Louis Lehot, business law partners at Foley & Lardner LLP in Silicon Valley

Why SAFEs will continue to dominate in early stages

Amidst historic highs for startup investment in 2021, and new records broken every month, one wonders whether we can expect the venture capital boom to continue. According to the data, demand for pre-seed and seed-stage deals are being driven by pent-up demand from volatile markets, and the necessity of innovation in light of the pandemic. The linchpin of venture capital investing, however, is the agreement between investors and the startup. While startups can choose from many options, at the pre-seed and seed stage, the current state of the market favors the SAFE instrument.

What is a SAFE?

A simple agreement for future equity (SAFE) is a funding instrument created in 2013 by Y Combinator, the well-known Silicon Valley startup accelerator. Originally intended to help startups raise seed capital, SAFEs have since grown into the ubiquitous alternative to the convertible note at pre-seed and seed-stage. For a comparison of the SAFE vs. the convertible note, read more here.

How does a SAFE work?

Prior to the introduction of SAFEs, startups often used convertible notes to raise pre-seed and seed capital from investors. Notes, whether convertible or not, are debt instruments, and evidence an obligation to pay money at maturity. A startup goes into debt to an investor, and the investor has the option to convert that debt into equity at some specified time later. Convertible notes have interest rates and maturity dates, just like other common debt instruments.

Unlike a convertible note, a SAFE is not a debt instrument. Instead, a SAFE is a convertible equity instrument which grants investors the right to purchase stock at a later date and under specific conditions. Think of a SAFE more like a warrant than a note. SAFEs are generally relatively short, much shorter than convertible notes. Y Combinator has since created several variations for both U.S. and non-U.S. companies.

Should you consider using a SAFE?

SAFEs come with a few key advantages over their debt-based alternatives. One advantage of a SAFE is that the startup does not incur debt due to the investment because it is not a loan. This feature helps to avoid pushing a startup into bankruptcy if it is struggling to gain traction or pivot to a new business model, or accrue interest over time. Having the investment debt drive a company into bankruptcy can be an unfortunate consequence of the convertible note.

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Another key advantage of SAFEs is simplicity. Y Combinator designed SAFEs to be simple so that startups could avoid racking up legal fees and reuse the SAFE for multiple investors. As Y Cominator notes, for a typical SAFE, only the valuation cap will need to be negotiated (if at all). Since the agreement is not a debt, startups and investors have no need to discuss maturity dates, extensions, or interest rates. They also have no need to negotiate around other investors.

Not everyone is keen on the idea of SAFEs, however. One particular concern is that under a SAFE, a startup may fail before it reaches the point where investors could exercise their options to buy stock. In that case, the investors have little recourse since the startup does not owe them a debt.

How has the coronavirus pandemic affected SAFEs?

The pandemic has fundamentally shifted how investors and startups connect. The industry is seeing a dramatic increase in virtual pitch meetings, and this has raised startups’ cadence of pitching to investors. As a result, startups will likely have more success if they can leverage this faster cadence through high-resolution fundraising. High-resolution fundraising requires negotiating with a larger number of investors, which is where SAFEs can really shine. As Y Combinator proclaims, for a typical SAFE, only the valuation cap will need to be negotiated. A startup can quickly bring in new capital without needing to coordinate between different VCs on any other point than the cap. Because they are simple and easily adapted to different investors, they may be a better choice than convertible notes or keep-it-simple-securities (KISSes), all of which have more complex terms to negotiate, particularly when you are trying to close deals quickly.

What to expect from pre-seed and seed financing markets in 2021

Nearly all startups accelerated by Y Combinator have used SAFEs, and the instrument has proved popular across the pre-seed and seed financing categories. Recent data from Crunchbase and others show a surge in venture capital financings at all stages of growth, and never before have we seen such a plethora of seed-funding options. Given the current realities of fundraising, SAFEs are worth considering. As always, investigate your options, do your due diligence, and see what works for your company.

Originally published here.