What are the Risks of a SAFE?

As founders look to raise capital, Simple Agreements for Future Equity (SAFEs) present a streamlined option. However, like any financial instrument, SAFEs come with their own set of risks. Understanding these risks is vital for making informed decisions and protecting the future of the business.

1. Valuation Cap Uncertainty

SAFEs come in different forms. One of those forms is the post-money valuation cap, which sets a maximum company valuation at which the SAFE will convert to equity. While this protects investors from excessive dilution, it can lead to uncertainty for founders. If a company grows rapidly and surpasses the valuation cap, more equity might be given away than anticipated. This dilution can affect control over the company and impact future fundraising rounds.

2. Lack of Investor Alignment

SAFEs do not offer investors the same rights as equity holders until they convert. This means investors might not be as engaged or aligned with the company’s long-term vision as traditional equity investors. Without voting rights or board seats, SAFE holders might take a more passive approach, potentially leading to less strategic guidance and support.

3. Conversion Timing and Impact

The timing of SAFE conversion can have significant implications. SAFEs typically convert during a priced equity round, like a Series A. If this round happens sooner than expected, unexpected dilution might occur. Conversely, if it takes longer to reach a priced round, investors might become impatient, leading to strained relationships or additional fundraising pressure.

4. Future Fundraising Challenges

While SAFEs are designed to simplify early-stage fundraising, they can complicate future rounds. Investors in subsequent rounds may view the existing SAFEs as a risk, as they will convert into equity, affecting the company’s cap table and ownership distribution. This potential dilution can deter new investors or lead to more challenging negotiations. Conversion can get especially hairy when multiple SAFEs are issued on varying terms.

5. Legal and Tax Implications

Although SAFEs are simpler than traditional convertible notes, they still carry legal and tax implications. The lack of a maturity date or interest payments can complicate the tax treatment of SAFEs for both founders and investors. Additionally, while SAFEs are generally considered founder-friendly, poorly drafted agreements, side letters or ancillaries can lead to legal disputes down the road.

6. No Opportunity for Future Cash Flow Relief

Unlike traditional debt instruments, SAFEs do not provide an option for cash flow relief. They are purely an investment in future equity, meaning there won’t be an option to defer payments or restructure the SAFE in times of financial strain. This can be a disadvantage if a company faces unexpected financial challenges soon before the SAFE converts.

Conclusion

While SAFEs offer a flexible and efficient way to raise early-stage capital, they are not without risks. It is crucial to understand these risks and weigh them against the benefits. By carefully considering the potential pitfalls and planning accordingly, SAFEs can be used effectively to support a company’s growth while protecting long-term interests.

Brandon J. Huffman

Brandon is the founder of Odin Law and Media. His law practice focuses on transactions and video games, digital media, entertainment and internet related issues. He serves as general counsel to the International Game Developers Association and is an active member of many bar associations and community organizations. He can be reached at brandon at odin law dot com.

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