January 23, 2015
How Safe are SAFEs? (Simple Agreements for Future Equity)
Posted by Christine Hurt

So, after swearing never to look at Above the Law again, I ventured over there to see if David Lat had posted an update on the Faruqi trial and found something relevant and interesting without the Judd Apatow feel of most ATL posts.  Here, "guest conversationalist" Zach Abramowitz intereviews Carolynn Levy, long-time Wilson, Sonsini attorney turned Y Combinator partner.  The interview focuses on Levy's contractual innovation, the safe.  (She says it's not capitalized or acronym-ed so that it will one day be a word as commonplace as "note").  However, a safe is a "simple agreement for future equity."  In other words, a convertible security, which founders and angel investors would use for early rounds of funding.  The advantages to a safe over a convertible note seems to be (1) it avoids clunky California lender licensing regulations (that were amended last year, however) and (2) according to Levy, much faster to negotiate than a note because a safe has neither a maturity date or an interest rate.

So, what is it?  According to the "safe primer," the safe is not debt (because no maturity date or interest rate), but it is an instrument that converts to a subset of preferred stock at the first equity round over a minimum valuation.  If there is no equity round, then the safe does not mature but just stays in place.  If the company fails, then the safe has a liquidation preference for the purchase price/principal.  If there is an acquisition liquidity event, then the safe holder has the option of converting to common or getting the purchase price returned.  

Of course, the stickiest wicket is the conversion rate for an equity round.  At the time the safe is executed, the parties will negotiate for a Valuation Cap and/or a Discount Rate, and depending on whether the parties chose one or the option of both, the holder will receive a subset of preferred stock either based on the Valuation Cap if it is lower than the equity round valuation, the equity round valuation if it's lower than the Valuation Cap, or a discount from the share price of the preferred.  Either way, Levy believes that having only one key term in the safe will create an easy negotiation and a six-page instrument.

I searched SSRN for any scholarly treatment of the safe and found this informative paper, Contractual Innovation in Venture Capital by John Coyle (UNC) and Joseph Green (Gunderson Dettmer).  It explains that the California regulation required lenders in venture capital debt to be licensed unless the notes in question had a maturity of no more than a year, requiring founders and angel lenders to renegotiate every 11 months.  In 2014, that limit was raised to 3 years.  In the meantime, however, Y Combinator produced the safe.

From the ATL interview, it seems that many lawyers are unfamiliar with the new convertible security, and others wondered whether it would be treated for tax purposes as debt or equity.  Zero coupon convertible bond?  Valuation Cap is the face value?  I don't have the asnwer for that, but will stay tuned.

I'm also interested in if this could be used for crowdfunding.

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