When your company is in its infancy, securing investors isn’t easy. From finding parties with enough money to presenting them with an acceptable risk and then paying transaction fees, the process can be daunting. That’s why more startups are turning to a newly developed method of raising capital called a simple agreement for future equity (known as a SAFE).
A SAFE is an agreement in which the investor’s money is considered advance payment for an amount of equity in the company. When the company undergoes an issuance of preferred stock, the investor is then able to obtain shares of this stock (often at a discount, depending upon the SAFE’s terms).
SAFEs can be issued with or without a valuation cap or a discount. For example, an investor enters into a SAFE with a 20 percent discount. Years later, the company raises an equity round at $2.00 per share. The investor’s SAFE allows him or her to buy preferred stock during that round at $1.60 per share—a 20 percent discount that other buyers don’t have. A SAFE can also include a most favored nation (MFN) provision, in which the investor can take advantage of more favorable terms if they’re offered to any future investors prior to the next equity round.
If this sounds familiar, you’ve probably heard it before in the description of a convertible note, which is a short-term loan that converts into equity at a future date. Indeed the two serve the same purpose: to bring in the funding needed to help a young company grow. And a convertible note also has the above-mentioned provisions available.
However, there are key differences. A convertible note is actual debt that requires a finite term for the loan. By a certain date, the note has to be “converted” into equity or some other stake in the company or else the loan must be repaid to the investor. A SAFE does not require any kind of end date, so an investor could wait indefinitely for his or her return. A convertible note also must have an interest rate on the loan, while a SAFE has no such requirement.
As a result, SAFEs are a simpler option that offers new companies more flexibility. However, they’re also a riskier prospect to investors since there’s no guaranteed repayment date and no interest payments on the investment while waiting on the next equity round.. Additionally, specific rules under generally accepted accounting principles (GAAP), IRS regulations and more play into whether they would be considered debt or equity on your company’s balance sheet.
You can establish a SAFE note agreement simply enough—by creating a written agreement between the company and the investor. In fact, you can obtain contract templates from a variety of sources, including government websites and online communities. Once the agreement is signed and witnessed as required, it can then be held until a triggering event occurs (such as an initial stock offering or subsequent equity round), at which time it would be executed.
While the setup is relatively simple, however, it’s imperative that you work with a tax professional familiar with SAFE options to determine which is right for your startup. Each party should also run the agreement by their respective legal counsels to ensure compliance and fairness for everyone involved. James Moore’s technology CPAs are well versed with these and other funding options, so they’re your best resource in making this important decision.
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