SAFE Gotcha Posted 2024-December

This post provides an investor-side view of SAFEs, as a more sophisticated complement to the founder-side post here. I would like to thank Ben Littauer for his thoughts and his co-development of this content.

DISCLAIMER: I am not an attorney and this is not legal advice. Consult an attorney if you have any questions on SAFEs or other agreements.

SAFEs are becoming more common, though there are still groups who refuse to touch them due to lack of investor protections (i.e., increased risk). The main “simplification” in a SAFE is the presumption of success, that the company will raise a priced round in a reasonable amount of time and that the SAFE will then convert.  In 2021-2, this was often true; now, it’s less so and the deficiencies of SAFEs from an investor point of view are much more apparent.  

We went through a period in roughly 2008 when convertible notes were “growing up” and becoming more popular for Seed rounds. (The term “pre-seed” was practically nonexistent.) All the things that investors learned about notes have been recognized as flaws in SAFEs, so they are now often corrected, usually in side letters. These include:

●       Information rights

●       Most favored nation clauses

●       Pro rata rights

●       Early exit “bonus” (e.g. 2x on a liquidity event before conversion)

Once you have some or all of these in place, the differences between modern notes and SAFEs become less meaningful. Notes are debt, and thus first in line when the company folds, and they have an interest rate and a maturity date. These differences rarely matter, although the latter is discussed below. These adulterated contracts are thus less SAFEs than they are CAFEs: Complicated Agreements for Future Equity.

The simplified agreement omits what happens in less-than-successful scenarios, and that creates additional risk for investors.  As you read the company’s SAFE, think through the following scenarios and, if appropriate, suggest that the company add provision for them. This is not an exhaustive list.

Scenarios below that are not covered in the SAFE terms are risks that should be enumerated in the diligence report and deal memo.

1. Zombie - the company earns enough to break even but does not grow fast enough to justify an equity raise.  Therefore, there is neither an exit nor a tax loss for the investor… indefinitely… until it is (hopefully) acquired.

➡️  Add a term for Maturity = investor options after 18 or 24 months.

                                               i.          Conversion to Common*

                                              ii.          Return of 25-50% of capital as cash

                                             iii.          Board seat

2. Debt or revenue-based financing (RBF) - the company raises material non-equity financing before a priced round.

➡️  Add a term to convert to Common* in such events

➡️  Add a term to reduce the price cap in such events

3. Exit before conversion (including acquihires)

➡️  Add a term so the SAFE is traded for 2X cash to investors at pre-conversion exit (could be 1.5X through 18 months and 2X thereafter)

4. Cash distribution - the company gets an influx of cash. This could be a grant, a large customer purchase, or a sale of assets (or equivalent). In such cases, the company may dividend the cash to equity holders.

➡️  Add a term so the SAFE pays cash to investors on Distributions as if it had been Common at the time of closing.

➡️  Add a term to convert to Common* prior to Distributions

* Conversion to common should occur substantially below the “price cap” of the SAFE, perhaps ½ of the cap, or this term is meaningless in practice.