Startup Financing: When Is A SAFE Not So Safe? – Directors and Officers

Startups have been raising money using the Simple Agreement for
Future Equity (SAFE) since it was first introduced by Y Combinator
in 2013. The advent of the SAFE has fundamentally changed the speed
and simplicity of early-stage fundraising for the better. The SAFE
has evolved since its introduction, and today a startup can choose
one of the forms of SAFE directly from the Y Combinator website,
fill in some basic information (investor name and amount), have an
investor sign it and be funded. It’s (almost) that simple!

Yet despite the simplification provided by the SAFE, over the
past few years we have seen an increase in additional terms
creeping into the SAFE and being presented as part of the
“standard” form; in many instances through a side letter.
Some startups, desiring to move fast and accept what they believe
to be industry-standard terms, do not realize that these additional
terms sometimes give investors significant advantages or rights
that the investor would not otherwise have with the standard SAFE
form, which could impact a startup’s ability to attract future
capital from investors. Here are some examples:

Board Seats

Some investors insist on having board representation in
companies in which they are making a significant investment,
including through a SAFE. The right to appoint a member to the
board has historically been a point of negotiation in preferred
stock financing rounds and not for startups raising money using a
SAFE. When agreed to by the company, the right to appoint a member
to the board of directors typically depends on the investor
maintaining a certain level of investment over time. In the context
of a SAFE financing, it is important to ensure appropriate
limitations are present. For example, if a SAFE were later
converted into shares of the company (a typical conversion for a
SAFE), the right to appoint the board member should sunset at that
time or be subject to the investor maintaining its equity stake;
otherwise, the investor may have the unlimited right to appoint a
member to the board—effectively ceding an unintended level of
control over the company to that investor for a much longer period
of time than initially bargained and potentially acting as a
“fly in the ointment” in the startup’s negotiation
with later investors.

Pro Rata Rights

Investors often demand the ability to maintain their ownership
percentage in a company by way of a pro rata or participation
right. This right is typically reserved for major or key investors
and is often subject to sunsetting if the investor no longer holds
a sufficient amount of equity in the company. In the context of a
SAFE investment, particular attention should be paid to calculating
the pro rata amount and providing for an appropriate sunsetting
event. If not, the startup may be providing the investor with the
ability to purchase far greater equity in the company’s next
financing round—possibly more leverage than the investor
would otherwise have at such an early stage of a startup’s
life. Having a diverse group of investors, and continuously
expanding that group of investors, is often considered critical so
that a startup does not become overly reliant on any one investor.
As such, ensuring that existing investors are not able to
“freeze out” new investors by buying up all the newly
offered equity should be top of mind.

Information Rights

Institutional or venture capital investors often demand that
certain information (e.g., financial, budget, cap table and even
board-level information) be provided by the startup to help the
investor monitor its investment. Careful attention should be given
to how much information the startup is agreeing to provide, and the
cadence with which the information is provided, through a SAFE
investment. For very early-stage startups, some information may be
excessive, too burdensome to manage or not even readily available
to the startup without significant time, effort or cost. In
addition, similar to the board seat and pro rata rights mentioned
above, information rights should also be subject to sunsetting.

In Conclusion

We expect the pace of startup financing using a SAFE to continue
to increase and evolve. The above investor rights—board seat,
pro rata and information—are very typical in startup
financings. It is important in the context of a SAFE financing to
understand the limitations and restrictions that should be placed
on these rights to ensure that the startup is not being
overburdened and that the investors are not granted too much
authority or future investment rights. Startups are wise to
carefully consider whether any of these terms could materially
affect the startup’s ability to attract later capital.
Additionally, negotiating additional or different terms for
different investors may defeat the purpose of using a
“simple” form of agreement. There is additional time and
cost required when negotiating these terms, not only during the
time of the initial investment but also at the time the SAFE
converts, especially if the SAFE has different valuation caps and
discounts. Startups should tread carefully when negotiating and
extending different terms for different investors and
“nontraditional” investor rights in the context of SAFE
financings.

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.