Startup Financing: When Is a SAFE Not So Safe?

Client Alert

Startups have been raising money using the Simple Agreement for Future Equity (SAFE) since it was first introduced by Y Combinator in 2013. The advent of the SAFE has fundamentally changed the speed and simplicity of early-stage fundraising for the better. The SAFE has evolved since its introduction, and today a startup can choose one of the forms of SAFE directly from the Y Combinator website, fill in some basic information (investor name and amount), have an investor sign it and be funded. It’s (almost) that simple!

Yet despite the simplification provided by the SAFE, over the past few years we have seen an increase in additional terms creeping into the SAFE and being presented as part of the “standard” form; in many instances through a side letter. Some startups, desiring to move fast and accept what they believe to be industry-standard terms, do not realize that these additional terms sometimes give investors significant advantages or rights that the investor would not otherwise have with the standard SAFE form, which could impact a startup’s ability to attract future capital from investors. Here are some examples:

Board Seats

Some investors insist on having board representation in companies in which they are making a significant investment, including through a SAFE. The right to appoint a member to the board has historically been a point of negotiation in preferred stock financing rounds and not for startups raising money using a SAFE. When agreed to by the company, the right to appoint a member to the board of directors typically depends on the investor maintaining a certain level of investment over time. In the context of a SAFE financing, it is important to ensure appropriate limitations are present. For example, if a SAFE were later converted into shares of the company (a typical conversion for a SAFE), the right to appoint the board member should sunset at that time or be subject to the investor maintaining its equity stake; otherwise, the investor may have the unlimited right to appoint a member to the board—effectively ceding an unintended level of control over the company to that investor for a much longer period of time than initially bargained and potentially acting as a “fly in the ointment” in the startup’s negotiation with later investors.

Pro Rata Rights

Investors often demand the ability to maintain their ownership percentage in a company by way of a pro rata or participation right. This right is typically reserved for major or key investors and is often subject to sunsetting if the investor no longer holds a sufficient amount of equity in the company. In the context of a SAFE investment, particular attention should be paid to calculating the pro rata amount and providing for an appropriate sunsetting event. If not, the startup may be providing the investor with the ability to purchase far greater equity in the company’s next financing round—possibly more leverage than the investor would otherwise have at such an early stage of a startup’s life. Having a diverse group of investors, and continuously expanding that group of investors, is often considered critical so that a startup does not become overly reliant on any one investor. As such, ensuring that existing investors are not able to “freeze out” new investors by buying up all the newly offered equity should be top of mind.

Information Rights

Institutional or venture capital investors often demand that certain information (e.g., financial, budget, cap table and even board-level information) be provided by the startup to help the investor monitor its investment. Careful attention should be given to how much information the startup is agreeing to provide, and the cadence with which the information is provided, through a SAFE investment. For very early-stage startups, some information may be excessive, too burdensome to manage or not even readily available to the startup without significant time, effort or cost. In addition, similar to the board seat and pro rata rights mentioned above, information rights should also be subject to sunsetting.

In Conclusion

We expect the pace of startup financing using a SAFE to continue to increase and evolve. The above investor rights—board seat, pro rata and information—are very typical in startup financings. It is important in the context of a SAFE financing to understand the limitations and restrictions that should be placed on these rights to ensure that the startup is not being overburdened and that the investors are not granted too much authority or future investment rights. Startups are wise to carefully consider whether any of these terms could materially affect the startup’s ability to attract later capital. Additionally, negotiating additional or different terms for different investors may defeat the purpose of using a “simple” form of agreement. There is additional time and cost required when negotiating these terms, not only during the time of the initial investment but also at the time the SAFE converts, especially if the SAFE has different valuation caps and discounts. Startups should tread carefully when negotiating and extending different terms for different investors and “nontraditional” investor rights in the context of SAFE financings.



pursuant to New York DR 2-101(f)

© 2024 Manatt, Phelps & Phillips, LLP.

All rights reserved