By Omoruyi Edoigiawerie, Esq
Start-ups face a unique obstacle with funding. They need funds to build their product or offering, test it, and release it to customers before they can generate income. But without any performance metrics or other proof they will be successful, start-up founders face enormous difficulty convincing investors to risk their money on their relatively unknown companies.

Another challenge lies in attempting to evaluate how much a brand-new start-up might be worth. This is because there is little basis or background for any valuation estimates, so the start-up and its investors often disagree on how much a company is worth in its early stages.

This disagreement normally becomes a clog in the wheel in the early-stage fundraising process. To find a solution, start-ups now offer a different type of investment opportunity, known as a SAFE agreement which is properly known as a Simple Agreement for Future Equity (SAFE).

A good start-up attorney will aim to help clients understand SAFE agreements, draft comprehensive SAFE agreements for clients, and provide advice and overall direction on these types of agreements so that start-ups can make the best choices for the short-term and the long-term.

In this article, we will examine what SAFE agreements are and why they are significant for start-ups.

*What is Simple Agreement for Future Equity (Safe)?

SAFE agreements are a relatively new type of investment agreement made between a company and an investor. SAFE agreements create potential future equity in the company for the investor in exchange for immediate cash to the company. The SAFE converts to equity at a later round of financing but only if a particular triggering event (outlined in the agreement) takes place.

The start-up accelerator Y combinatory introduced the SAFE in late 2013, and since then, it has been used by many start-ups as the main instrument for early-stage fundraising.

To understand what a SAFE is, it is also important to examine what it is not. It is not a debt instrument. It is also not common stock or convertible notes. That said, SAFEs are similar to convertible notes in that they both provide equity to the investor during a future preferred stock round and can include valuation caps or discounts. However, unlike convertible notes, SAFEs do not accrue interest and do not have any specific maturity date. More often than not, it may never be triggered to convert the SAFE to equity.

*How does a safe work?

Typically, a start-up company and an investor agree to negotiate several things, but key among the things they negotiate include valuation caps, discounts, maturity date/event, and investment amount.

Once the terms are agreed upon and the SAFE is signed by both parties, the investor sends the company the agreed funds. The company then applies the funds according to any relevant terms and conditions. The investor does not obtain the equity (SAFE preferred stock) until an event listed in the SAFE agreement triggers the conversion. Events that could trigger the conversion of the agreement may be Future equity financing or the Sale of the company.

In the meantime, a SAFE that has not matured is treated like any other convertible security.

*Why does safe matter to start-ups?

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SAFEs are used by start-ups specifically as a new way to raise money. But they can be significant to a start-up’s growth because they are:

1. Relatively easy to create and implement;

2. Do not accrue interest as a loan does; and

3. Offers flexibility in the way the company raises funds.

These three points can be instrumental in attracting investors to the company. They also involve less risk that often accompanies other types of investments. SAFEs are something akin to a problem-solver for start-up companies. To put this in proper context, SAFE agreements help resolve the following “teething” issues that affect start-ups:

1. Debt. Debt is a problem for start-ups. As the label indicates, these companies are just starting and trying to find a home in the market. Debt creates stress that stunt company growth. It is also often the reason start-ups fail. For instance, convertible notes are often used by investors but they are debt instruments. SAFEs are not debt instruments and, as such, remove the threat of solvency. If the company fails, the owners do not have the burden of paying back the investor (but if the company succeeds, in part because it’s not burdened with lots of debt, the investor reaps the benefits alongside the company).

2. Paperwork. Paperwork is energy- and time-consuming. This is particularly problematic for start-up companies because their focus needs to be on growth and scaling up and operations and many other things but no paperwork. When investors, for instance, invest using convertible notes, maturity dates are attached to these investments. The problem is that once the date of maturity is due, many start-ups are not ready. As a result, they must request maturity date extensions which ultimately results in more paperwork. With SAFEs, however, no extension is required because there is no maturity date.

3. Standardisation. Standardized agreements are a burden because they impose specific standards and require specific terms, clauses, or provisions. Standardization in itself is not a problem because it offers consistency and expectation, but it also denies customization. This is a problem for start-ups because they are unique and new to the market and customization can help them grow and develop in a way distinct from competitors. SAFEs are not standardized. Terms can be negotiated (to benefit the start-up), including terms related to conversion, repurchase rights, dissolution rights, and voting rights.

4. Control. When investors invest in start-ups, part of their immediate return on the investment stocks in the company. Common stocks render voting rights to investors. With voting rights, investors can partake in the shaping of the company. The problem is that the owners of the company often want to keep control of the company’s shaping for as long as possible to make sure their vision materializes as intended. When voting rights spread out among more people that control diminishes. With SAFEs, current equity stakes in the company are not provided, so the investor does not receive stocks and, therefore, does not receive immediate voting rights.

•Conclusion

SAFE agreements offer a simpler alternative for obtaining seed funding in comparison to other options like convertible notes, which are notoriously more complicated. Because they do not have a set maturity date or any interest rate attached, they are considered relatively straightforward in most cases.

However, start-ups must resist the urge to rely on templates and gloss over the details. Expert advice is important to ensure that you do not impact adversely issues like the company’s valuation cap, investment discounts, and strategic timelines.

Omoruyi Edoigiawerie is the Founder and Lead Partner at Edoigiawerie & Company LP, a full-service law firm offering bespoke legal services with a focus on start-ups, established businesses, and upscale private clients in Nigeria. The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances. His firm can be reached by email at hello@uyilaw.com