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SAFE contracts: the future of investment

Each startup project needs funding and investments at the beginning of its journey. The early stages, the so-called seed rounds, are the most difficult in terms of raising capital, as there are many risks and there is no ready-made business model yet. Nowadays, there is a number of various methods of raising funds, which can be divided into two categories: priced round and convertible instruments. The first group includes the sale of shares of the company, and the second – c onvertible notes and SAFE contracts.

When selling shares, the investor funds a certain amount in exchange for a certain number of shares in the company. The exchange takes place immediately. However, in order to use the share purchase agreement, the company must go through an evaluation procedure. Usually, it is impossible to fairly evaluate a startup project at the stage of an idea or market testing. In addition, obtaining shares will give the new shareholders of the company the right to vote and decision-making powers, which may impede the founders of the project with its further development.

Compared to the priced round, convertible instruments are much simpler to compose, easier to negotiate and faster to execute. Convertible note – is a form of investment in which the investor lends a certain amount, which after a certain period of time the company will either pay back with interest or convert into shares. It allows to postpone the issue of evaluating the company for later, but in addition to interest, this type of agreement also has a “maturity date” – the deadline upon reaching which the startup must convert early investments into shares or return the money.

In 2013, the leading American business accelerator Y Combinator published a new financial instrument – SAFE contract.  SAFE (Simple Agreement for Future Equity) is designed to simplify the process of investing in startup projects at early stages. The contract itself is publicly available and consists of less than 10 pages, which makes it simple and understandable for a wide range of investors. SAFE is similar to a convertible note in that it postpones business valuation and investment conversion to a future date. However, SAFE is not a debt, it has no interest rate and no “maturity date”.

Under a SAFE contract, an investor can receive money in three ways:

1. At the next investment round of the company, the investor receives the shares of the company corresponding to his initial investment;

2. When the company is sold or listed on the stock exchange, the investor receives a sum of money in the amount of his proportional share of the company’s capitalization immediately before this event;

3. Upon liquidation of the company, the investor receives a return of the investment or, if the company does not have sufficient funds for a full return, its proportional share of the balance of the company’s funds.

SAFE contracts also have mechanisms to attract investors and protect their funding, such as:

· Discount rate;

· Valuation cap.

Discount rate is the amount of the discount determined by the agreement that the investor receives on the share price when converting his investments. In other words, the investor will receive the company’s shares at a price lower than they are valued on the market.

Valuation cap is the maximum valuation of the company, according to which the investor will be able to receive the company’s shares upon conversion. That is, a company capitalization limit is set, according to which the investor has the right to receive his number of shares, according to the initial investment. If the share capitalization has not reached this limit, then the conversion is calculated according to the existing valuation, if the capitalization has exceeded the limit, then the valuation is carried out according to the established maximum limit.

There are also agreements in which both clauses are included at once: discount rate and valuation cap. In this case, the number of the share is calculated according to the option that is most beneficial to the investor.

Despite a number of positive aspects, SAFE agreements still have shortcomings. Those are:

· No minimum investment threshold for conversion – the minimum size of the investment round is not established by the agreement. If the company decides to conduct a micro-round to obtain the necessary funds, it will be required to make a conversion and receive new shareholders in the form of investors. The solution to this problem can be to establish a minimum amount of the round that entails the conversion.

· No deadline – the company may or may not hold the next investment round, go public or liquidate. The investor becomes a hostage of the situation and is forced to wait until one of the abovementioned events occurs. Establishing a reasonable term for the agreement would save investors from this risk.

· Accreditation of investors – being an American invention, SAFE is subject to the US Securities Act. According to this law, a company that raises funds is required to obtain an investor’s assurance that he is accredited (owns a net worth of at least $1,000,000 or has an annual income of at least $200,000). However, if the agreement specifies that the investor is not a US resident and will not resell his SAFE rights to US residents, then the above requirement is waived.