Staying SAFE with your Start-up Financing

Amélie Côté [1]
ROBIC, LLP
Lawyers, Patent and Trademark Agents

Every technology-based start-up faces tremendous hardships, whether it be asset valuations, the protection of its intellectual property or ultimately staying ahead of the competition.  However, the first hurdle to overcome is often obtaining adequate financing. The legal instruments used by venture capitalists in Canada often consist of debt security in the form of convertible promissory notes or the issuance of convertible preferred stocks.  In the past years, there has been a notable increase in Canadian investors using an alternative instrument, adopted from the American Silicon Valley: Simple Agreements for Future Equity (“SAFEs”).  Although they are effectively simple, as their name suggests, their use within start-ups needs to be carefully evaluated and adapted on a case-by-case basis.

1. What are SAFEs?

The Y Combinator, one of the top American seed accelerators[2] located in the Silicon Valley, introduced the concept of Simple Agreements for Future Equity, otherwise known as SAFEs, in late 2013.[3]  These unique financing instruments allow for investors to convert their investment into equity upon the closing of a subsequent equity financing of preferred shares.  Due to their ability to allow for fast, efficient and cost-effective financings, SAFEs are now being used across the globe for seed financing of start-ups. 

2. Variations

SAFEs generally vary with respect to three elements which are negotiated between the parties: a valuation cap, a discount and a most favored nation clause. In fact, a SAFE can have one or a combination of these elements.

• Post-Money Valuation Cap: Investors may opt to negotiate a cap at which its investment will convert. As such, the investment will convert into equity at the lesser of (i) the valuation of the subsequent equity financing; or (ii) the valuation cap.
• Discount: A discount may be applied at the time of conversion.  In these cases, an investor under a SAFE containing a discount will, upon the closing of a future equity financing, see its investment convert into a number of shares equal to the investment at a discounted price. 
• Most Favored Nation Clause: Such a clause would allow the investor to convert its investment into equity on terms which are the same as those which may have been offered to subsequent investors. 
• Key Advantages

3. SAFEs generally have the following advantages:

• Simple: As stated in their title, SAFEs are relatively simple in, both their form and their use.  The template agreements provided by the Y Combinator[4] average around five (5) pages, whereas convertible promissory note agreements require multiple agreements which may be much lengthier.  Furthermore, SAFEs do not require consent the coordination of a single closing with all investors simultaneously.[5] As such, negotiations for SAFEs are usually relatively short in comparison to other types of financing instruments.  In fact, the main negotiable terms consist of the valuation cap, the discount and the MFN, if applicable. 
• No Valuation Required: Unlike other financing instruments, SAFEs do not require the parties to evaluate, negotiate and determine the value of the corporation, which is often a lengthy and costly process.
• Interest-Free and Debt-Free: Since SAFEs do not constitute debt, they not only do not need to be disclosed on a company’s balance sheets, but they also do not accrue any interest. 
• Conversion into Preferred Shares: SAFEs typically provide that there will be conversion of the investment into preferred shares of the corporation. This differs from many standard note purchase agreements which often provide that the investment will convert into common shares of the corporation.
• No Repayment: SAFEs do not typically contain provisions providing for the repayment of the investment in certain cases, which is usually the case in convertible debt securities. 

4. SAFEs: The Appropriate Legal Instrument for your future financings?

At the time of the introduction of the SAFE model by the Y Combinator, the agreement was disclosed as having “advantages of convertible debt without some of the disadvantages”, notably maturity dates and interest.[6]  However, although SAFEs may be well adapted for many Silicon Valley start-ups, their introduction among Canadian and Quebec start-ups may pose some issues, notably for investors who are unwilling to accept the inherent risks of a SAFE. In fact, SAFEs remain simple contractual agreements under which a cash investment is converted into stock upon the fulfillment of a condition: the completion of a preferred share financing round.  As such, if there is no preferred share round, then SAFEs run the risk of never converting into equity.  This differs greatly from secured debt instruments, which will always convert or become payable at some point in time, whether it be at a future priced round or a given maturity date. 

5. Conclusion

Although the injection of capital by using a SAFE may seem like an obvious choice due to its many advantages, these agreements do have particularities which may impact a business in the long run.  Furthermore, most SAFEs templates which are readily available are based on U.S law and lack several particularities which apply in Canada and the province of Quebec.  As such, each and every Canadian start-up would be wise to have their businesses evaluated by both financial and legal professionals in order to ensure that they are using the legal instruments which are adapted to their financing needs, whether they be traditional debt security instruments, or more modern instruments such as the SAFE or the Keep it Simple Securities[7].