SAFE and KISSEarly stage and startup companies often face difficulty in obtaining initial financing.  These companies normally do not have access to traditional venture capital, angel, or bank financing.  Even when a startup finds an investor, the company may not have the time or the funds to pursue the long and complicated negotiation and documentation process required for a convertible debt or preferred stock investment.

Y Combinator (a Silicon Valley technology accelerator) developed a possible solution for this situation:  the SAFE (Simple Agreement for Future Equity). This is a short document that contains the basic terms of an investment in an early stage company. Y Combinator’s goal was to create a standard set of terms and conditions that the investor and the startup can agree upon without protracted negotiations so that the startup can obtain its initial funding relatively quickly and cheaply. Y Combinator offers both a summary of SAFE concepts and sample SAFE documents on its site.  Y Combinator first proposed this instrument in December 2013, but it is just now beginning to be used outside of Silicon Valley.

While the SAFE has appeared in a number of forms, the basic concept is that the investor provides funding to the company in exchange for the right to receive equity upon some future event.  The standard SAFE contains no term or repayment date, and no interest accrues.  The investor gets the right to receive the company’s equity when a future event occurs (normally a future equity financing). There is no need to spend time or money negotiating the company’s valuation, the terms of the conversion to equity or any similar items (which can often be tough and protracted negotiation items) – all of those decisions can be deferred into the future. The investor will receive shares in the subsequent offering, often at a discount to the price that other investors pay in that offering. The parties can also negotiate a cap on the valuation used in connection with the SAFE, and this may provide additional protection to the investor.

The beauty of the SAFE concept (from the company’s standpoint) is that it defers the major terms of the investment to a future transaction, and thus allows the initial financing transaction to proceed much more quickly and cheaply.

The use of a SAFE may require a change in the investor’s mindset. An investor must be willing to move to a more “pro-founder” position to use a SAFE because of the uncertainties involved and the lack of traditional investor protections. A SAFE investor is relying on the terms of the subsequent financing round (over which it normally will have no control) to protect its position.

So what are the downsides of SAFEs? For the company, there are few initial problems or concerns. The SAFE concept speeds up the early stage financing process and also reduces costs (primarily legal fees). The potential downside here, however, is that the company will be committed to issuing equity on the terms of the next round of financing. If that next financing round is done on unfavorable terms, the company will still be committed to issue equity to the SAFE holder on these unfavorable terms (and often at a discount to these unfavorable terms). For example, if a low valuation is required in the next financing, the SAFE investor could be entitled to a substantial number of shares. This could hurt the economics of the company and could negatively affect the founders’ control position.

SAFEs can cause more serious problems for the investor. The primary problem here is uncertainty. As with the company’s position, there is no way to predict when the next financing round will occur and what the terms will be. The SAFE investor will be required to accept whatever valuation the company ends up using, as well as the other terms that the company agrees to (although this concern can be mitigated by a valuation cap). Additionally, what if the company never does the next round of financing?  This could occur, for example, if equity financing is not available.  The standard SAFE document does require the company to repay the purchase price to the investor if a liquidity event or change in control occurs, and this may provide some additional investor protection.

The status of SAFEs where the company encounters financial problems is unclear. A SAFE is not debt or equity, and it appears that a SAFE will be classified as merely a contract right. It’s difficult to see how the investor can protect its position in a negative economic scenario.  Of course, even with a full convertible debt instrument in place, how much viable economic protection does an investor actually have when the borrower is a startup company?  In this scenario, a debt investment may not offer much more protection than a SAFE.

Investors must take a serious look at this situation if they contemplate using a SAFE since their protection in a downside event will be minimal. The only way to use a SAFE with any degree of comfort is to have confidence that the company has a clear path to a subsequent equity financing event on favorable terms. This is easy to say but often hard to accomplish.

Despite these concerns, the SAFE concept is a significant step forward in facilitating early stage company funding, and I applaud Y Combinator for thinking outside the box. A similar organization, 500 Startups, has recently developed a similar alternative investment vehicle called a “Keep It Simple Security” or KISS. Other organizations will likely develop similar alternative investment structures, and investors and lawyers will continue to tweak the terms. This trend should continue to benefit early stage and startup companies.