A Simple Guide to SAFEs – the Simple Agreement for Future Equity

A Simple Guide to SAFEs – the Simple Agreement for Future Equity

SAFEs, or Simple Agreements for Future Equity, are investment instruments sold by startups in early-stage fund raising. While related to equity, they are not considered traditional equity instruments at the time of their sale or issuance. Instead, a SAFE is a contract that gives the investor the right to convert the amount invested (the “Purchase Price”) to equity (meaning an ownership interest) in the issuing company at a future date. That future date is typically, the Company’s first preferred stock financing round (e.g., a Series Seed or Series A preferred stock financing). To reward the SAFE holder as an early startup investor, the SAFE typically converts either at a stated percentage discount from the price offered to new investors in the preferred stock round or pursuant to a favorable valuation cap.

Since being introduced by Y Combinator in 2013, SAFEs have largely displaced convertible promissory notes as the preferred instrument for early stage startup fund raising. The SAFE presents itself as a standardized instrument (in few alternative forms) requiring little negotiation. It permits startup founders to close with each investor separately as soon as both parties are ready to sign, and the investor is ready to wire money. This is more efficient than having to wait and coordinate single closing simultaneously with a multiple investors. As a fast, flexible, one-document instrument with few items to negotiate, SAFEs save startups and investors money in legal fees and reduce the time spent negotiating investment terms. And, in current practice, early stage companies raising investor money largely treat SAFE financings as independent seed rounds capable of providing multi-year runways, rather than a shorter-term bridge to priced preferred stock rounds as Y Combinator had originally envisioned in 2013.

Pre-Money vs. Post-Money SAFE

There are actually two different “standardized” SAFE templates, each with a few variations: the original or the “Pre-Money SAFE,” and that which Y-Combinator introduced in 2018 to replace it, the “Post-Money SAFE.” While both forms are in use in the market, the Post-Money Safe is now predominant, and the only one Y Combinator still advocates.

It says it introduced the Post-Money SAFE to bring more transparency to the percentage of equity each SAFE investor could expect to receive on conversion to equity and to provide the startup founders with greater insight into the extent each successive SAFE would dilute their ownership percentage.

While there a number of technical differences between the Post-Money and Pre-Money SAFE, the most important permits the investor in a Post-Money SAFE essentially to lock in a certain percentage of the equity in relation to other shareholders (including other SAFE investors) – calculated as of immediately prior to conversion to equity. In Post-Money SAFEs, the valuation cap, which sets the maximum company valuation for converting the SAFE investment into equity, includes in its calculation the aggregate amount invested under all SAFEs, with each SAFE’s conversion to equity being calculated independently from that of other SAFEs. In contrast, under a Pre-Money SAFE, the conversion into equity does not include the conversion of SAFEs to equity in its calculation – the result being each SAFE is diluted by all other SAFEs.

Primary Features of Post-Money SAFEs

The primary features of the Post-Money SAFE include the following:

Conversion. SAFEs convert into shares of the issuer’s stock upon a triggering event, typically the company’s first preferred stock financing round. For most early-stage companies, this is either a Series Seed or Series A financing. At the time of this financing the SAFE converts into equity of the issuer after applying any early-stage incentives included in the SAFE (i.e., valuation caps or price discounts) relative to the price paid by the new (preferred stock round) investors. Such preferred stock rounds are often referred to as “priced rounds” because, during these rounds, the company and its new investors agree on the exact price per share of the stock being sold, which in turn gives a specific valuation to the company at the time of the investment.
Early-Stage Incentives. SAFE investors are typically provided with one or more incentives relative to the priced round investors for their early investment in the company: a discount rate, a valuation cap, or (rarely) both.
- Discount Rate. SAFEs can include a conversion discount rate that lets the SAFE holder buy shares at a lower price (about 10-30% less) than that which the other investors in a priced round pay. For example, if the Series Seed price per share is $0.60 per share and the SAFE reflects an effective discount rate of 20%, on conversion, the Purchase Amount the SAFE holder invested converts into Series Seed stock at $0.48 per share. See Y-Combinator’s PDF template Safe: Valuation Cap, no Discount.
- Valuation Cap. The valuation cap defines the maximum valuation at which a SAFE converts, effectively creating a floor for the SAFE holder’s conversion. For a more complete description of the valuation cap, how it works, and the structure and features of the Post-Money SAFE generally, please see Y-Combinator’s downloadable Quick Start Guide and its Post-Money User Guide. See also Y-Combinator’s template Safe: Valuation Cap, No Discount.
- Discount Rate + Valuation Cap. Some SAFEs have both a valuation cap and a discount rate. If this is the case, the SAFE investor only converts under that incentive provision (discount rate or valuation cap, but not both) which results in the greatest discount for the investor.
- Most Favored Nation (MFN). This is a SAFE with no Post-Money Valuation Cap and no Discount Rate. It is only used where the company and the investor decide to punt on conversion terms (frequently the only items negotiated) , believing the company is highly likely to set those terms with a future SAFE investor. If the company subsequently issues SAFEs with provisions that are advantageous to the investors holding this SAFE (such as a Valuation Cap and/or a Discount Rate), the investor may choose to amend its SAFE to reflect the terms of the later-issued SAFEs. The amendment term is the so-called “MFN Provision.” If there is a priced round equity financing before this SAFE is amended pursuant to the MFN Provision, the investor receives the same shares of preferred stock as the new money investors in the priced round, at the same price. If there is a liquidity event before this SAFE is amended by the MFN Provision, the investor is entitled to receive a portion of the proceeds equal to the SAFE Purchase Amount. See Y-Combinator’s template Safe: MFN, no Valuation Cap, no Discount.

Absence of Conversion Event

The dependence on a future conversion event reflects a material part of the risk to an investor of investing in a SAFE with the goal of ultimately owning an issuing startup’s capital stock. If a company fails to secure future equity financing or gets acquired, then an investor’s SAFE will never convert into equity.

Company Acquired before Conversion Event. Here the startup is acquired before completing a VC funded priced round, a “Liquidity Event” in SAFE terms. The Post-Money SAFE provides the holder with the option of receiving value that is the greater of (1) 1x their investment back in cash and/or other forms of consideration (e.g. acquirer stock), or (2) the amount payable on the as-converted ownership of the SAFE. This is done via the defined term “Proceeds” – which covers all proceeds payouts from the Liquidity Event, whether stock or cash – and specifying the SAFE holder receives the portion of Proceeds that is the greater of the Purchase Amount or what would be payable on the as-converted ownership of the SAFE (in this case to common stock as there is no preferred stock).
Company Dissolves without a Conversion Event. In this scenario (“Dissolution Event”) the startup fails before it can secure VC money in a priced round. Here, the SAFE holder holds a contractual right to repayment of the Purchase Price, but it’s unlikely there would be anything meaningful available to pay the SAFE holder.
The Safe’s Priority in Relation to Other Claims. The SAFE’s priority in relation to other claims (debt, wages, etc.) and securities in a Liquidity Event or Dissolution Event ranks below all debt but potentially above or at the same level as some types of equity, depending on their specific terms and the conditions under which they convert.

Usage

As mentioned, the Post-Money SAFE has evolved as a primary investment instrument issued by early stage startups seeking quick capital infusions while deferring additional variables for a later date. As a fast, flexible, one-document instrument with few items to negotiate, SAFEs are generally regarded as saving startups and investors money in legal fees and reduce the time spent negotiating investment terms. And, like equity investments in early stage startups, they are generally considered high risk investments.

Disclaimer: This summary is made available by DPA Law PC (the “firm”) for informational purposes only. It is not meant to convey the firm’s legal position on behalf of any client, nor is it intended to convey specific legal advice. Accordingly, do not act upon this information without seeking counsel from a licensed attorney engaged to provide advice based on your specific circumstances. This article also is not intended to create, and receipt of it does not constitute, an attorney-client relationship. This article is published “as is” and is not guaranteed to be complete, accurate, or up to date.