Safe for investors: A look at Simple Agreements for Future Equity (SAFEs) from the perspective of an investor

Simple Agreements for Future Equity (“SAFEs”) are a common way for startups and high-growth companies to raise funds.

In our previous article, we provided a broad, general walk-through of the features and mechanics of SAFEs. In this article, we focus on the key terms and conditions an investor should review and understand prior to entering into a SAFE and provide some practical tips about how to address common issues that investors run into when investing using a SAFE.

We always encourage investors to consult with qualified financial and legal professionals before entering into a SAFE and making the investment.

Conversion price

For an investor in a SAFE, a goal is usually to obtain the highest amount of equity upon the conversion of the SAFE for the lowest price. When investing in SAFEs, investors will also want to be mindful of impacts of dilution and certainty with respect to the percentage ownership of the company the investor will have upon conversion of the SAFE. This calculation should consider the conversion of other investors SAFEs and the impact of the future equity financings.

Valuation caps

Valuation caps function to provide a ceiling on the SAFE’s conversion price and, as a result, can increase the number of shares that are issuable under the SAFE when the SAFE converts. With an upward limit on the conversion price, this provides investors with protection for preserving the percentage ownership of the company the investor can expect to have following conversion of the SAFE and can provide the investor with a conversion discount in some circumstances.

Valuation caps are usually negotiated on a pre-money or post-money basis and can offer certain benefits to investors. From the perspective of an investor, the best form of valuation cap is a post-money valuation cap. This is because, at the time of conversion, the valuation cap is divided by the capitalization of the company, including the conversion of all the issued and outstanding SAFEs. This gives investors more certainty by providing a fixed percentage of the company a SAFE will convert to prior to the triggering event, regardless of how many other SAFEs are issued in the meantime. Accordingly, post-money valuation SAFEs provide investors the advantage of certainty of ownership and dilution only affects the founder’s shares.

Discounts

In some cases, the issuer of the SAFEs will not include a valuation caps. Instead, they will offer investors in the SAFEs up to a 10% to 30% discounted conversion price to the price to be paid by third-party investors during a future equity financing. But this discount doesn’t provide much certainty of value if the price can be determined by a company in any future equity financing.

To help ensure that the price paid by third-party investors is the fair market value, investors can require that the company raise a minimum floor amount of funds in the future qualified equity financing in order to automatically convert the SAFE (for example, $3 million). This minimum conversion floor requirement acts as a safeguard to prevent the company from issuing a small amount of equity shares at a price determined by only a few investors. Instead, with a minimum conversion floor, the SAFE holder can have comfort that the discount will be applied to a price that reflects the value agreed upon by a larger pool of third-party investors.

Due diligence and contractual representations and warranties

One of the main purposes of SAFEs as an investment instrument is to raise money quickly, without a valuation, and defer lengthy contract negotiations and due diligence processes to a future date.

While this is desirable for companies, it can often leave investors exposed to undesirable legal risk and/or consequences.

Many startups do not issue SAFEs in connection with a subscription agreement or other purchase agreement for the issuance of SAFEs. Accordingly, when investors give companies funds, in most cases, those investors typically do not conduct extensive due diligence or receive representations and warranties about the company and are not indemnified by the company for any inaccuracies or misrepresentations about those representations and warranties.

Instead, investors are often required to provide a broad covenant in the SAFE that obliges them to enter into the same transaction documents that are entered into by third-party investors at the time the SAFE converts, including the subscription agreement and a shareholders agreement, usually without any requirement for their consent, input or approval.

This requirement is problematic for investors because there is no guarantee that the third-party investors in a qualified future equity financing will have their counsel conduct an extensive due diligence process on the company to the standard of those SAFE investors and/or negotiate for comprehensive contractual protections in those documents into which they are bound to enter.

Practical options to help protect investors

There are a few practical options for investors to consider to give them some protections. An investor could:

1. Request that the shareholders agreement of the company, if any, is drafted at the time of the SAFE offering and a copy provided to the investor in advance. The SAFE could include a covenant that the only shareholders agreement that the investor must enter into is that version of the shareholders agreement. An investor that wants to go one step further, could ask for a consent right on any future amendments to that shareholders agreement. As discussed below, this could be done in a side letter.
2. Either have the company provide a in connection with the SAFE transaction, which includes a comprehensive set of representations and warranties at the time of the SAFE transaction, or have the company covenant in advance that any subscription agreement will include a pre-determined set of representations and warranties. While these are creative ways to solve an obvious gap in SAFE offerings, either of them would be considered abnormal and above and beyond what is considered market.

Share class

In many cases, the class and/or series of share that will be issued to a SAFE holder upon the conversion of a SAFE, hasn’t been created and/or established and, as a result, investors are unable to determine the characteristics of the shares they will receive upon conversion. In some extreme cases, the SAFE will not event confirm if the shares will be common or preferred shares or voting or non-voting shares.

An investor should always consider either:

1. Establishing and reviewing the rights of the shares that they will receive upon the conversion of a SAFE or
2. Ensuring that the SAFE entitles them to the most senior class of preferred share that exists at the time of any conversion of the SAFE.

No shareholder rights

A SAFE is an agreement to automatically convert into equity of a company at a future date. Accordingly, until a SAFE is converted, the holder generally does not have any rights as a shareholder.

Notwithstanding this fact, there are options to ensure that investors have some protection. Investors can:

1. Include contractual protections that they are entitled to any dividends that are declared on shares based on their investment amount, on a fully converted basis.
2. Ensure that in the event of a liquidity event, that the holders of SAFEs are treated as holders of notional preferred shares and entitled to priority distribution from proceeds and/or assets over any existing shareholders.
3. Enter into a side letter that puts on the activities of the company for the duration of the SAFE.

We recommend that you consult your own legal advisers when preparing a SAFE to ensure that you are in compliance with Canadian securities laws.

If you are an investor that is interested in investing using a SAFE, please contact Kyle Mirecki in our Winnipeg office or Mark Mielke in our Calgary office.

Note: This article is of a general nature only and is not exhaustive of all possible legal rights or remedies. In addition, laws may change over time and should be interpreted only in the context of particular circumstances such that these materials are not intended to be relied upon or taken as legal advice or opinion. Readers should consult a legal professional for specific advice in any particular situation.

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