Early Stage Investments are no longer done (only) by way of a Sale of Shares or Loans

A Discussion over SAFEs and other Alternative Investment Formats

There are many types of investment agreements and numerous ways to invest in business ventures and startups. Until a few years ago, the most common methods were either the sale of startup shares to investors or the provision of a convertible loan, where investors lent money to the company with the option to convert it into equity. In recent years (around a decade ago), a new style of investment agreements has emerged, leading to a new type of transaction known as SAFE. These are the initials for Simple Agreement for Future Equity.

The SAFE agreement was developed by the Y Combinator accelerator from Silicon Valley to create a simple format for investment transactions and, in doing so, to solve some of the major issues created by convertible loan agreements. For example, it provided a solution to the interest problem, where interest accrued on the loan was almost always paid in shares, yet the tax on the gain from this interest had to be paid in cash by investors or, at times, by the company upon their request.

Another objective behind the creation of the original SAFE was to reduce transaction costs and avoid prolonged negotiations, which often arose in equity investment rounds. Such rounds required amendments to startup incorporation documents to reflect the preferential rights granted to investors (e.g., the right to appoint a board member, veto rights on specific corporate actions, right of first refusal, and more). Those who designed this format also aimed to standardize these agreements and establish a market standard for early-stage investment transactions.

These objectives were partially achieved by various SAFE users, as many investors saw the format as a mere recommendation and made changes to incorporate the preferential rights mentioned above. Some investors did not modify the SAFE agreement itself but drafted a side letter with the company (Side Letter), granting them additional rights and detailing deviations from the format. The reason for this is often that the investor and the company do not want these changes to apply to all investors in the round, or they wish to keep these arrangements confidential.

Over time, SAFE transactions spread beyond the American market, where they originated, and reached our region as well. For instance, between 2016 and 2018, when I served as in-house counsel for an Early-Stage fund, I saw SAFE transactions increasingly dominate the fund’s deal flow. With time, however, many investors realized that the SAFE format presented long-term challenges. One example is the absence of an at-will conversion clause allowing the investor to convert the investment into company shares at any time (usually into the most senior share class at the time).

The lack of such a provision created a "trapped investors" scenario, where companies reached break-even (matching revenue with expenses) without raising another funding round, resulting in cases where the SAFE investment never converted into equity until an exit (if at all). Many investors found themselves in a powerless position, sometimes lacking even basic rights to company updates and information. At first glance, this situation seems to benefit the company, but no company, as any entrepreneur who has exited will tell you, can thrive in the long run if its investors are dissatisfied.

These and other issues were addressed by a new format, which, unfortunately, has not yet gained enough traction—the Advanced Equity Agreement or Advanced Investment Agreement. It does not have flashy initials, but it resolves all the issues that arose in previous formats, adds certainty to transactions (by incorporating representations and more detailed conversion clauses absent from SAFE), and keeps transaction costs low, about one third the cost of an equity transaction and half the cost of a convertible loan transaction. At the same time, it eliminates all the problems that SAFE created for investors while minimizing the impact on the company compared to SAFE.

During my time as legal counsel at a venture capital fund, we used this format extensively. Our fund loved this transaction structure so much that we developed a custom template tailored to our investment profile. This format was so non-aggressive and fair to all parties that negotiations were typically short—and, to the best of my recollection, usually the shortest of all investment transactions we handled.

In recent years, we have learned that investing in startups does not have to be limited to equity purchases or convertible loans. The new path for Early-Stage investments is not just SAFE, the Advanced Investment Agreement is, in my view, a much better alternative. That said, each transaction is unique, and there are still cases where an equity investment round remains the best option.

It is essential to consider all relevant parameters, including the company’s status, round size, timeframe until the next required investment, and the state of the company’s incorporation documents. More on the Advanced Investment Agreement in the next article…