What Is a SAFE?

A Simple Agreement for Future Equity (SAFE) is a contractual convertible financing agreement between a startup and its investors (SAFE Investor) in which the investment converts to equity when the startup raises a future round of funding.

The SAFE sets out the terms and conditions regarding when and how the capital would convert into equity. Unlike a convertible note, a SAFE is not a debt instrument, does not accrue interest or have a maturity date.

The “pre-money” SAFE was introduced by Y Combinator(the world’s preeminent startup accelerator) in late 2013 to allow startups to receive their first investment quickly and easily. This worked fine when the size of funding rounds was smaller and when the SAFE immediately preceded a Series A round.

However, as the SAFE became wildly popular among startups, it was used to raise larger rounds of funding. Meanwhile, startups were frequently raising multiple rounds of funding on SAFEs. That created confusion around the exact formula to convert the SAFE into equity.

In order to address that issue, in 2018, Y Combinator released the “post-money” SAFE, which allows founders and investors a better ability to precisely calculate ownership percentage and dilution of each SAFE. This clarity is essential if founders want to scale their company while still retaining the appropriate ownership at each stage. As such, the post-money SAFE has become the industry standard.

Advantages

SAFE has been welcomed by the startup community for several reasons.

  • Fast and easy.—SAFEs published on Y Combinator’s website are around six pages long.They are fairly simple and straightforward with fewer variables to understand and negotiate.
  • No interest payment and maturity date.—SAFEs remove features in convertible notes that give startup founders headaches, such as interest payments and maturity dates. This allows founders to better focus on growing the company.
  • No repayment of principal.—SAFEs published on Y Combinator’s website are around six pages long.They are fairly simple and straightforward with fewer variables to understand and negotiate.
  • High-resolution fundraising.—With the SAFE, startups can close with an investor as soon as both parties are ready to sign and the investor is ready to wire money, eliminating the coordination required of a typical round. Y Combinator founder, Paul Graham, calls this high-resolution fundraising.

Disadvantages

Despite all the convenience discussed above, SAFE is sometimes not so simple or safe.

  • No equity stakes.—SAFEs are not equity stakes in the company, so SAFE investors are not protected under state corporate law or federal securities law. Instead, SAFE investors are entitled to a future equity stage only if certain triggering events occur. If the triggering event never occurs, a SAFE investor can be left with nothing.
  • Too easy.—Ironically, the main feature of the SAFE—its simplicity—is also a bug.Because it’s become so easy for founders to raise money on SAFEs, many founders raise a bunch of money without understanding the impact on the cap table. Then they have arude awakening when the SAFEs convert, and they realize how much of their company they’ve given away and how much it has diluted them.

How Does It Work?

The SAFE defines equity financing as a bona fide transaction or series of transactions with the principal purpose of raising capital, pursuant to which the company issues and sells preferred stock at a fixed valuation, including but not limited to, a pre-money or post-money valuation. Essentially, this is any future round of financing that is a priced round. Unlike the qualified financing in the convertible note, there is no minimum threshold.

Y Combinator has drafted four versions of the SAFE. They are:

  1. SAFE: cap, no discount
  2. SAFE: Discount, no valuation cap
  3. SAFE: Valuation cap and discount
  4. SAFE: MFN, No valuation cap, no discount

In the fall of 2021, Y Combinator removed number three, the SAFE: Valuation cap and discount from their website (without explanation). However, it remains a popular version of SAFE.

Side Letter

A side letter is an agreement between the investor and the company that is supplementary to the main financing agreements—in this case, a SAFE. The standard Y Combinator SAFE side letter includes Pro Rata Rights, which allows the SAFE investor the right, but not the obligation, to purchase its share of stock being sold in future financings. Pro rata rights are generally perceived as a fairly neutral term. However, from time to time, SAFE investors attempt to throw a laundry list of additional rights and preferences into a side letter.

In general, it would be preferable for founders to avoid side letters mainly because the administrative burden of keeping track of who has which rights at conversion is challenging and overly complex.

What Are the Most Crucial Provisions of a SAFE?

Conversion

Upon an equity financing, the capital that the SAFE investor invested converts into shares of preferred stock in the company. The shares will have the exact same preferences, rights and restrictions as the preferred shares of the new investors in the equity financing (new investors). So, founders should remember that when they are negotiating the terms of the investors in an equity financing, they are negotiating for the shares of the new investors as well as the SAFE investors. The number of preferred shares that the SAFE will convert into depends on whether there is a discount and/or a cap.

Discount

The discount in a SAFE is used as a mechanism to address the higher risk of investment that SAFE investors take when investing in an early-stage startup. It is a discount off the price per share paid by new investors in the equity financing. The discount may range anywhere between 5% to 30%, with 20% being the norm.

Sometimes the discount alone may not be sufficient in protecting an early investor’s interest. Thus, some investors will use a valuation cap in SAFE to protect their interests in circumstances where the company is growing a lot more rapidly than expected.

Valuation Cap

A valuation cap is a projection of the maximum price (ceiling) at the subsequent round of equity financing rather than an actual pre-money valuation. If the SAFE has a valuation cap, it’s typically the most heavily negotiated term.

The best-case scenario for founders is for the SAFE to be uncapped but discounted. The discount allows the SAFE investor to be rewarded for their early risk. But it avoids the problem of trying to set some random value on the company, which could turn out to be incredibly high or low.

Setting a valuation cap at an appropriate level requires understanding your company thoroughly and knowing the commercial value your business can bring. Founders should not treat a valuation cap as a valuation and should never let potential investors get away with that argument. When faced with a valuation cap negotiation, founders should ensure that the valuation cap is set at an appropriate level, ideally at a level higher than the company could achieve if it were to do a priced equity round of financing.

Most Favored Nation (MFN)

The Most Favored Nation clause (MFN) allows early SAFE investors to receive favorable terms as future SAFE investors. The MFN-only SAFE has no discount or valuation cap. Instead, it gives the SAFE investor the right to participate on the same terms as future SAFE investors. The MFN clause acts as downside protection in the event that a more savvy or powerful investor is able to negotiate a better deal than they were able to negotiate.

A SAFE with MFN only (no valuation cap) saves the stress and challenges that entrepreneurs and investors face when negotiating the appropriate valuation cap while balancing the intent to protect early investors for the additional risks they take. However, it has to be adopted with caution.Disputes on MFNs can be complicated, and they often lead to lawsuits between founders and investors.

Conclusion

The SAFE is designed to get early investments into the company quickly and simply. As we’ve addressed, there are some complex mechanisms to this “simple” agreement. As such, please note that the FAQ is designed for a high-level grasp of the pros and cons of a SAFE. It is not legal advice and does not replace the need for counsel. Skilled counsel will help you understand which terms to negotiate and how to negotiate them. They will also ensure that the business terms are accurately reflected in the operative documents. Without allowing for adequate consideration to these mechanisms, you may suddenly find yourself converting multiple SAFEs, which each have different terms too close to the Discount and a Valuation Cap with no clear path forward. This is not at all a “SAFE” position to find yourself. Please see our Founder’s Guide: SAFE, which will have a deeper dive into SAFEs.

Please see our Founder’s Guide: SAFE, which will have a deeper dive into SAFEs.

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