Reddit. Dropbox. Airbnb. These are just three of over 1,400 startups which have obtained early-stage funding, guidance, and support from West Coast tech accelerator Y Combinator since 2005. In 2013, Y Combinator began utilizing a new and novel instrument for many of its seed-stage investments: the Simple Agreement for Future Equity (SAFE). Since then, SAFEs have played an increasing role in equity crowdfunding markets, representing approximately 1-2 percent of equity crowdfunding for accredited investors (Regulation D platforms under Rule 506(c)). As you evaluate funding strategies for your start-up, you should consider whether the SAFE is a viable and advisable option.
What is the SAFE?
As the name implies, the SAFE is an agreement pursuant to which the investor receives a pledge of future equity, usually preferred stock, upon the occurrence of an evaluation event such as an acquisition or IPO. In this sense, SAFEs serve the same purpose as convertible notes, with one very important distinction: there is no obligation to repay.
What are the key features of SAFEs?
As Y Incubator itself describes them, some key aspects of SAFEs that make them an attractive funding tool include:
- A SAFE is not a debt instrument and therefore doesn’t contain the baggage -such as maturity dates, security interests, or subordination agreements – that can often turn a convertible note into a crushing burden.
- Since the funds invested through the SAFE are not a loan, no interest accrues.
- As a one-document security with minimal terms to negotiate (pretty much just the valuation cap and share price), the SAFE should streamline the funding process and reduce the time and expense involved in negotiations and attorney review (though you should always get a lawyer’s input and advice before entering into a SAFE).
Accounting treatment of SAFEs
This is where the debate begins – how to properly account for SAFEs on your company’s balance sheet. We have received several questions on this topic. Some argue that SAFE are, in essence, warrants for future shares in the company. They should be treated as such for accounting purposes, and booked with a value equal to the amount of the capital contribution. The SAFE’s value would vary with the value of the business, but because of the existence of the valuation cap, it would not have a completely linear relationship with the company’s value.
Others argue that SAFEs should be recorded as debt. Getting a little technical, accounting guidance ASC 480 provides an example: “480-10-55-22 Certain financial instruments embody obligations that require (or permit at the issuer’s discretion) settlement by issuance of a variable number of the issuer’s equity shares that have a value equal to a fixed monetary amount. For example, an entity may receive $100,000 in exchange for a promise to issue a sufficient number of its own shares to be worth $110,000 at a future date. The number of shares required to be issued to settle that unconditional obligation is variable, because that number will be determined by the fair value of the issuer’s equity shares on the date of settlement. Regardless of the fair value of the shares on the date of settlement, the holder will receive a fixed monetary value of $110,000.” Based on the example, this would be recorded as a liability. Further, ASC 480-10-25-14 states: “A financial instrument that embodies an unconditional obligation, or a financial instrument other than an outstanding share that embodies a conditional obligation, that the issuer must or may settle by issuing a variable number of its equity shares shall be classified as a liability (or an asset in some circumstances) if, at inception, the monetary value of the obligation is based solely or predominantly on any one of the following:
- A fixed monetary amount known at inception (for example, a payable settleable with a variable number of the issuer’s equity shares)”
The choices you make when seeking capital early in your company’s lifespan will play a large role in determining whether your hard work and personal investment will bear fruit. You should evaluate your options carefully and consider the benefits and potential costs of all available funding avenues before choosing the one that best serves your interest and goals.
If you have any questions regarding SAFEs or other funding strategies for your early-stage company, please contact us. We welcome the opportunity to assist you.