SAFE agreement: What it is and how it works

Simple Agreement for Future Equity (SAFE) agreements have recently become a popular instrument for startup financing. These agreements are a contractual promise between investors and your startup: the investor provides venture capital now in exchange for startup equity later (provided certain trigger events occur).

Unlike traditional equity investments, SAFEs are designed to be straightforward and founder-friendly, deferring the valuation discussion until a later financing round. SAFEs offer a compelling alternative to the complexities of equity sales and the rigid repayment schedules of debt financing. They provide a quick injection of funds without immediately diluting ownership, allowing you to maintain control while growing your business.

However, there are a few nuances that make this financing tool a bit more complicated. Below, we’ll walk you through everything you need to know about SAFE agreements and how they work so you can determine if it’s the right startup funding solution for your business.

What is a SAFE agreement?

A SAFE (Simple Agreement for Future Equity) agreement is an innovative investment instrument that allows startups to secure funding from investors without immediately issuing equity. They serve as a contractual promise to provide your SAFE investor with equity at a future date (under specific conditions) without the complexity of a traditional equity round.

Y Combinator introduced SAFEs back in 2013 to simplify the process of early-stage investing, and it caught on quickly with the rest of the startup ecosystem.

SAFE agreements have become a go-to financing tool because of their simplicity and flexibility. Unlike traditional equity investments, there are no immediate valuations required, and they typically have fewer terms and conditions. Key features include:

• Equity conversion: SAFEs convert into equity at a later date, usually during a subsequent funding round or an event like an IPO.

• Valuation caps: SAFEs often include a valuation cap to protect founders if they grow faster than expected, setting a maximum company valuation at which the investment will convert into equity.

• Discount rates: Investors may also be granted a discount rate, allowing them to convert their investment into equity at a lower price than later investors.

• No interest or maturity date: Unlike debt, SAFEs don’t accrue interest or have a maturity date, reducing immediate financial pressure on the startup.

Traditional financing options for startups often include either issuing equity or taking on debt. Equity financing involves selling a stake in the company, which can be expensive and dilutive if the startup’s valuation is low. Debt financing requires regular interest payments and eventual principal repayment, which can strain a startup’s cash flow.

SAFE agreements offer a middle ground.

They provide capital without immediate equity dilution or the financial burden of monthly payments. They are particularly attractive for startups with high growth potential but uncertain valuations.

However, they’re not perfect. Keep in mind that SAFEs can still lead to dilution when the agreement converts into equity, and the terms of conversion can be a game-changer for investors and your startup.

How do SAFE agreements work?

When investors provide funding under a SAFE, they do so with the understanding that their cash infusion will convert into company shares during certain triggering events. Triggering events might be a future fundraising round, initial public offering (IPO), or liquidity event like the sale of the company.

Valuation caps and discounts are critical components of SAFE agreements that protect investors and founders and provide incentives:

• Valuation caps: These caps set a maximum valuation at which the investor’s funds will convert into equity. If the company’s valuation at the next funding round is higher than the cap, the investor’s SAFE converts at the valuation cap, leading to less dilution for the founders.

• Discount rates: Discounts allow investors to convert their SAFE into equity at a price lower than the next round’s investors, rewarding them for their early-stage fundraising. For example, a 20% discount would enable your early investors to convert their investment into equity at 80% of the price new investors pay in the next round.

Advantages and drawbacks of SAFE agreements for startups

When it comes to financing, your startup has likely already weighed a handful of options. With equity financing declining in today’s macroeconomic environment and founders wanting to avoid debt, SAFE agreements provide a nice balance.

However, while SAFE agreements offer a range of benefits, they aren’t without their complexities and potential pitfalls. Below, we’ll walk you through the advantages and drawbacks of SAFE agreements, providing a balanced perspective to help you determine if they align with your startup’s financial strategy and long-term goals.

Pros of SAFE agreements

• Flexibility and simplicity: SAFE agreements offer a high degree of flexibility, allowing startups to secure funding without the complexities of equity or debt financing. They are straightforward and quick to execute, which means you can raise capital faster and with fewer negotiations.

• Minimized dilution: The dilution of ownership only occurs during a future financing round (not immediately). This helps you retain more control over your company in the early stages and reduce dilution as your company’s valuation has an opportunity to grow.

• Speed of funding: The simplicity of SAFE agreements often translates into faster funding. Without the need to agree on a company valuation or navigate the intricacies of equity terms, startups can receive funds more quickly to fuel growth.

• No debt obligations: SAFE agreements don’t accrue interest or require regular payments, allowing you to spend your investment on growing your business.

• Access to strategic partners: Your startup can use SAFE agreements to bring on strategic investors to provide capital, mentorship, industry connections, and operational expertise.

Cons of SAFE agreements

• Lack of standardization: There’s no agreed-upon format for SAFE agreements, leading to variations and complexities. Each SAFE can have different terms, and this lack of standardization can create confusion and potential legal complications.

• Potential for misalignment: SAFE agreements can sometimes lead to misalignment between founders and investors, particularly if the future valuation doesn’t meet expectations. Investors may feel they’ve overpaid if the company’s valuation is lower than anticipated at the conversion event.

• Uncertainty for future valuations: If your startup’s valuation at the time of conversion is significantly higher than at the time of the SAFE investment, it can lead to substantial dilution for existing shareholders, including founders.

• Limited investor rights: SAFE investors typically have fewer rights than equity holders. They may not have voting rights or a seat on the board, limiting their ability to influence the company’s direction.

• Future complexities: Multiple SAFE agreements with varying terms can complicate future financing rounds. New investors may be wary of the terms given to previous SAFE holders, potentially affecting the terms of new investments or the willingness of new investors to participate.

How to negotiate a SAFE agreement

You’ll want to hire legal and accounting help to help draft and confirm your SAFE agreements—they’ll be equipped with the know-how and expertise to help protect your startup. Here are a few best practices to keep in mind as you negotiate these agreements:

1. Understand the terms and conditions

Create a term sheet that outlines the conditions you’re willing to accept and those you want to negotiate. This should include valuation caps, discount rates, pro rata rights, and conversion triggers.

Use financial modeling tools to understand how different scenarios will affect your ownership and control of the company.

2. Align interests with investors

Find investors who offer more than just capital. The right investors bring industry expertise, networking opportunities, and strategic value to your startup.

Be transparent about your business plan and growth strategy. This helps set realistic expectations and builds trust with potential investors.

3. Come in with a plan

Enter negotiations with a clear understanding of your startup’s valuation and how it justifies the terms you’re proposing. Be prepared to discuss your startup’s milestones, financials, and market potential.

Practice your pitch and negotiation points. Anticipate questions and challenges from investors and prepare reasoned responses.

4. Focus on building relationships

Treat SAFE negotiations as the beginning of a long-term relationship with your future investors. Aim for terms that are fair and equitable to both parties—neither you nor the investors should be trying to cheat each other.

Communicate regularly with potential investors before, during, and after negotiations. Keep investors informed about your progress and send regular investor updates to build a more collaborative relationship.

Build your long-term potential with DigitalOcean

SAFE agreements provide a powerful financing tool for your startups, delivering valuable capital without the immediate pressure of valuation and equity dilution. They capture the lean, fast, forward-thinking ethos of modern startups looking to navigate and grow in a competitive landscape.

As you consider the right SAFE agreement for your startup, remember that it’s not just about securing funds—it’s about forging partnerships and setting the stage for future success. And in the dynamic world of startups, your choice of infrastructure and tools is just as important as your financing strategy.

DigitalOcean provides a robust platform that empowers startups to build, deploy, and scale applications efficiently and cost-effectively. Our intuitive cloud infrastructure lets you focus on innovation and growth, knowing that your digital foundation is solid, scalable, and supportive of your journey—wherever it may take you.

Explore our solutions designed for startups like yours, and discover how we can help you optimize your operations, reduce costs, and accelerate your path to success.