When a SAFE investment is not necessarily safe

Part I of two-part series

Q

I am a successful entrepreneur who has decided to make an angel investment in a small startup company.

I asked for preferred stock in the company, but the founders have offered me something called a SAFE instead. I’ve read the paperwork, and I confess I’m a bit confused about exactly what I’m getting. Reading about SAFEs online, it sounds like they’re pretty controversial. Can you say a few words about these in one of your columns?

A

You need to understand some basics.

There are two ways — and only two — someone can invest in a company:

1) The investor makes a loan to the company and gets paid back with interest (this is called debt).

2) The investor makes an investment in the company and gets a percentage of its future profits and losses (this is called equity).

Generally, if the company fails, investors who make loans get their money out first, but their upside is limited to the interest on their loans. They have no right to manage the company or make decisions about the business.

Investors who make equity investments get their money out last if the company fails, but their upside is unlimited: The bigger the company gets, the more money they make. They also have the right to manage the company and make important decisions about the business.

Many angel investors like to straddle the fence between debt and equity — they want to participate in the business’s growth and be able to take their money out first if things don’t work out. A number of instruments have been created to make that possible.

Most common is preferred stock. This is an equity investment (so the stockholder gets a percentage of the company) that also has a liquidation preference allowing the investor to get money out before the other equity investors do. Another is the convertible note, a debt instrument that can be converted into a percentage of the company at a future date.

The most recent instrument to come along is the SAFE, or simple agreement for future equity (see the SAFE Wikipedia page for more information).

Created by startup funding firm Y Combinator in late 2013, the SAFE is a contract between a company and an investor under which the investor puts money into the company in exchange for a promise to receive equity at a future time if certain goals are met — usually upon the company obtaining a round of venture capital financing.

Unlike a convertible note, in which the investor gets interest until the note converts into equity, the holder of a SAFE gets no interest until the “triggering event” occurs entitling him or her to equity. Also unlike a convertible note, in which the investor knows exactly how many shares (or what percentage of the company) he or she will get upon converting the note, a SAFE is intentionally vague about what the investor will get when the triggering event occurs, which explains why it isn’t technically either debt or equity.

Unlike preferred stock, SAFE holders do not get dividend payments until the triggering event occurs. Also, it may not be clear whether the holder qualifies for a liquidation preference should the company fail or be acquired by another.

Unlike preferred stock or convertible notes, there is no need to value the company when the SAFE is issued. This saves the company tons of money and avoids a valuation event that becomes the floor below which future equity cannot be issued. Instead, the company will be valued at the time the triggering event occurs, and the SAFE holder will get shares based on how much they originally invested at that future valuation.

Often the future valuation will be capped at a fixed dollar amount, or the SAFE holder will get shares at a price discounted from what the company offers future investors, which gives investors some idea of what they will get if and when the triggering event happens. With many SAFEs, the investor also has a “preemptive right” to add to the SAFE investment when the company engages in future financing rounds, thus enabling the investor to preserve his or her percentage ownership of the company when the triggering event occurs.

To make things more interesting (or complicated), since September 2018, SAFEs can be either “pre-money” or “post-money.” The distinction is a technical one (for a detailed analysis, see Ramy Adeeb’s article “The New Post-Money SAFE — What Founders and Investors Should Know,”) but it basically breaks down to this:

• The post-money SAFE gives investors greater protection against dilution (the reduction of an investor’s percentage ownership when new investors pile on at a later time) for if a company decides to raise money in multiple SAFE rounds of financing.

• The post-money SAFE doesn’t automatically give investors a preemptive right to make additional investments in order to avoid dilution from subsequent rounds of financing.•

Look for part two in next week’s issue.

Cliff Ennico (crennico@gmail.com) is a syndicated columnist, author, and former host of the PBS television series “Money Hunt.” Opinions expressed are those of the author.

© 2019 Clifford R. Ennico Distributed by Creators.com