## Introduction The *Simple Agreement for Future Equity (SAFE)* has become a cornerstone in the landscape of startup financing, offering a streamlined, flexible approach to early-stage investment. Introduced by [Y Combinator in 2013](https://www.ycombinator.com/documents), SAFEs were designed to simplify the process of early-stage funding, providing an efficient and founder-friendly alternative to traditional financing methods such as convertible notes. This essay delves into the history of SAFEs, their structure, advantages, and disadvantages, offering a comprehensive guide for founders and investors. %% An important point to note is that while the essay will briefly touch on the original, "pre-money" SAFE, this focus will be on the terms and details of the new, "post-money" SAFE that was introduced in 2018 since this is the version that is used in the ecosystem today. %% ## History and Evolution of Startups Financing %% https://www.latitud.com/blog/convertible-note-safe-priced-equity-round-difference %% In the early days of startup investing, the most common form of investment was a *priced equity round.* In these rounds, investors agree to invest a certain amount of capital in exchange for equity in the company at a set price per share, which is determined after a thorough valuation of the company. This is what most people think of when discussing startup/company financing. Priced equity rounds presented significant challenges for early-stage startups for several reasons (more details in our [[Priced Equity Rounds|deep-dive]] on priced equity rounds): - **Difficulty in Establishing Valuation**: Early-stage startups often lack substantial traction, revenue, or a proven business model, making it extremely challenging to determine an accurate valuation. This uncertainty could lead to either undervaluation or overvaluation, both of which had negative consequences. Undervaluation could result in excessive dilution of founders' equity and losing control of the company early on, while overvaluation could set unrealistic expectations, make it hard to grow into the new valuation, and complicate future funding rounds. - **Time-Consuming and Costly**: Priced equity rounds required extensive due diligence, legal documentation, and negotiations, making the process time-consuming and expensive. Early-stage startups, which often operate with limited resources and tight timelines, could find the process overwhelming and distracting from core business activities. - **Inflexible Fundraising Amount**: Fixed-size equity rounds require startups to decide in advance how much capital they intend to raise. This can be problematic for early-stage startups since they may not know their future capital needs and need a more "raise-as-you-go" model. A solution was found in *convertible notes*. Convertible notes allow startups to raise money from investors in the form of a loan with a fixed interest rate and a maturity date. When the startup eventually raises a priced round, the loan (plus accrued interest) converts into equity in the startup. Convertible notes are a form of unpriced financing that allows the startup and the investor to defer discussions of the company's valuation to a later date when the startup has more traction, revenue, and a clearer business model. It also allows the startup to raise funds on a rolling basis, allowing them to infuse capital into the business as needed. Paul Graham has a great [essay](https://paulgraham.com/hiresfund.html) on convertible notes and its advantages over price equity rounds. You can also check out our [[Convertible Notes|deep-dive]] on convertible notes for more details. However, convertible notes introduce a different set of complexities: %% https://www.toptal.com/finance/startup-funding-consultants/convertible-note %% - **Repayment Obligations**: What happens if a startup cannot, or chooses not to, raise equity financing by the maturity date? Given that most startups at this stage are still burning cash, they do not have the ability to repay the loan. At this stage, startups face a few choices: negotiating with note holders to extend the maturity date, automatic conversion of the note to equity on pre-set terms, or repaying the loan plus accrued interest. Each of these options takes away time and resources from the startup. - **Risk of Default**: The note holder can choose to initiate bankruptcy proceedings if the startup fails to repay the loan or does not secure a priced equity round by the maturity date, potentially leading to the liquidation of the startup's assets to satisfy the debt. - **Complex Negotiations**: Convertible notes require detailed negotiations around terms such as the maturity date, interest rate, conversion discount, and valuation caps. These terms can be intricate and require significant legal and financial expertise to navigate. In 2013, to address the above challenges, Y Combinator introduced the _Simple Agreement for Future Equity (SAFE)_ to further simplify the process of early-stage funding. SAFEs are a form of unpriced financing similar to convertible notes in that the exact valuation is determined at a later stage. But unlike convertible notes, SAFEs are not structured as debt instruments, so they do not accrue interest or have a maturity date. SAFEs solved a lot of the problems presented by convertible notes: - **No Repayment Obligations**: Unlike convertible notes, SAFEs do not have a maturity date or accrue interest, eliminating the pressure of repayment and the risk of default. - **Simplified Negotiations**: SAFEs streamline the investment process by focusing on fewer terms, primarily the valuation cap, making negotiations faster and less complex. - **Flexibility**: SAFEs allow startups to raise funds on a rolling basis, similar to convertible notes, but with less complexity and risk. The initial version of the SAFE was called the "pre-money" SAFE, which calculated the investor's ownership before accounting for the SAFE money. This version worked well for smaller rounds but created uncertainty for investors regarding their exact ownership percentage until the next financing round (explained in more detail later in the essay). In 2018, YC introduced the "post-money" SAFE, which calculates the investor's ownership *after* all the SAFE money is accounted for. This provided more clarity for investors as they could immediately see how much equity they would own once the SAFE converts. This had some important differences from the "pre-money" SAFE: - **Immediate Ownership Clarity**: SAFE holders know exactly how much equity they will own after the safe converts, improving transparency and planning. - **Better Dilution Understanding**: Founders can better understand the dilution impact of each SAFE they issue, helping them manage their equity more effectively. Post-money SAFEs have quickly become one of the most popular instruments for early-stage startup financing because they provide a straightforward, efficient, and transparent method for raising capital. Startups benefit from the simplicity and speed of the post-money SAFE, allowing them to focus more on growth and product development rather than getting bogged down in lengthy negotiations or complicated legal documents. Moreover, founders gain clearer insights into how much equity they are diluting, while investors enjoy greater predictability regarding their stake in the company. This clarity fosters trust and facilitates smoother fundraising rounds, making post-money SAFEs a preferred choice for many startups looking to secure funding efficiently and with fewer hurdles. According to [Carta](https://carta.com/blog/state-of-pre-seed-fundraising-q2-2023/), SAFEs accounted for 80% of pre-seed invested capital in Q2 2023. ## Pre-Money SAFE As mentioned briefly earlier, SAFEs are a form of *unpriced financing*, meaning that they allow investors to provide capital to a startup without determining the company’s valuation at the time of investment. Instead of receiving shares immediately, investors receive a promise that they will get equity in the future, typically when the company raises its first priced round, such as a Series A. ### How Pre-Money SAFEs Work When a startup raises money through pre-money SAFEs, it issues agreements to investors with the promise of future equity. The percentage of equity each investor will eventually receive is not determined at the time of the SAFE issuance. Instead, the conversion into shares happens during the first priced round, where the company’s valuation is officially established. This causes a level of uncertainty for investors since they do not know how their ownership percentage will compare to other stakeholders until the first priced round occurs. ### Impact of Subsequent SAFEs With pre-money SAFEs, each new SAFE issued before the priced round affects the overall equity distribution. If multiple SAFEs are issued, each investor’s final ownership percentage will be influenced by the total amount of SAFE money raised and the terms of each SAFE. For example, if a company raises a SAFE in year 1, then raises another SAFE in year 2, the holder of the second SAFE ends up diluting all the previous stakeholders, including the holder of SAFE 1. As a result, pre-money SAFE holders do not know their equity % in the company (and how much they were diluted) until the priced round. ### Conversion and Dilution during Qualified Funding When the company raises its first priced round, all outstanding pre-money SAFEs convert into equity. The conversion process takes into account the valuation cap of each SAFE and the total pre-money valuation of the priced round. The percentage ownership for each SAFE investor is calculated based on these factors, leading to the final equity distribution. This will be made clear with a detailed example below. ### Example Let's use an example to see how Pre-Money SAFEs work: **Initial Cap Table:** At the time of founding, let's say Company X has the following cap table: | Stockholder | # Shares | % Ownership | | ------------------------ | -------- | ----------- | | Founders | 100,000 | 100% | | Total Outstanding Shares | 100,000 | | **Pre-Money SAFE 1:** Company X then raises a pre-money SAFE with the following terms: - Amount raised: $500,000 - Pre-money valuation cap: $4.5 million (= $5 million post-money cap) Number of new shares to be issued: - Price per share = `$4.5 million / 100,000 = $45`. - Number of shares to be issued = `$500,000/$45 = 11,111` Cap Table after SAFE 1: | Stockholder | # Shares | % Ownership | | ---------------------------------------- | -------- | ------------------------- | | SAFE 1 holder<br>(when converted at cap) | 11,111 | `11,111/111,111 = 10%` | | Founders | 100,000 | `100,000 / 111,111 = 90%` | | Total outstanding shares | 111,111 | | **Pre-Money SAFE 2:** A year later, Company X raises another pre-money SAFE with the following terms: - Amount raised: $1.5 million - Post-money valuation cap: $8.5 million (= $10 million post-money cap) Number of new shares to be issued: - Price per share = `$8.5 million / 111,111 = $76.5`. - Number of shares to be issued = `$1.5 million / $76.5 = 19,608` Cap Table after SAFE 2: | Stockholder | # Shares | % Ownership | | ------------------------ | -------- | --------------------------- | | SAFE 2 holder | 19,608 | `19,608/130,719 = 15%` | | SAFE 1 holder | 11,111 | `11,111 / 130,719 = 8.5%` | | Founders | 100,000 | `100,000 / 130,719 = 76.5%` | | Total Outstanding Shares | 130,719 | | Note that raising the second pre-money SAFE diluted everyone else on the cap table, including the first pre-money SAFE holder. **Series A:** - Amount raised: $5 million - Pre-money valuation cap: $15 million (= $20 million post-money cap) Number of new shares to be issued: - Price per share = `$15 million / 130,719 = $114.75`. - Number of shares to be issued = `$5 million / $114.75 = 43,573` Cap Table after Series A: | Stockholder | # Shares | % Ownership | | ------------------------ | -------- | ----------------------------- | | Series A Investor | 43,573 | `43,573 / 174,292 = 25%` | | SAFE 1 holder | 11,111 | `11,111 / 174,292 = 6.375%` | | SAFE 2 holder | 19,608 | `19,608 / 174,292 = 11.25%` | | Founders | 100,000 | `100,000 / 174,292 = 57.375%` | | Total Outstanding Shares | 174,292 | | %% As mentioned above, the first SAFE introduced in 2013 was the pre-money SAFE, which calculated the investor's ownership before accounting for the SAFE money. This version worked well for smaller rounds but created uncertainty for investors regarding their exact ownership percentage until the next financing round. At the time of its introduction, startups were raising smaller amounts of money in advance of raising a priced round of financing (typically, a Series A Preferred Stock round). The safe was a simple and fast way to get that first money into the company, and the concept was that holders of safes were merely early investors in that future priced round. A pre-money SAFE has the following terms: - Startup raises a certain amount (say $500,000) at a specific pre-money valuation cap (say $5 million). The pre-money valuation cap is what makes the SAFE "pre-money". - The valuation cap sets a maximum valuation for the conversion, providing a lower-priced share for the investor if the actual valuation exceeds the cap. For instance, if a startup raises a series A at a $10 million pre-money valuation, the SAFE holder will be allocated shares based on a $5M valuation. Without the valuation cap, if the startup does very well after raising money from SAFE holders and raises a giant priced financing round, the SAFE holders will be reduced to an extremely low equity position. The valuation cap ensures that the SAFE holder is guaranteed to hold a minimum amount of equity. %% ## Post-Money SAFE In 2018, YC introduced the "post-money" SAFE, which calculates the ownership stakes of the SAFE holders _after all the SAFE money is accounted for_. This means that if a startup raises $500,000 with a post-money SAFE at a $5 million post-money valuation cap, the SAFE holder will own exactly 10% of the company after the SAFE converts, regardless of any other outstanding SAFEs. ### Advantages Over Pre-Money SAFEs - **Immediate Ownership Clarity**: SAFE holders know exactly how much equity they will own post-conversion. This transparency is crucial for investors who want to understand their stake in the company immediately after their investment. - **Better Dilution Understanding**: Founders can better understand the dilution impact of each SAFE they issue, helping them manage their equity more effectively. This clarity helps in planning future fundraising rounds and in negotiating terms with investors. ### Example Let's use the example from the pre-money SAFE section to see how post-money SAFEs work. **Initial Cap Table:** | Stockholder | % Ownership | | ----------- | ----------- | | Founders | 100% | **Post-Money SAFE 1:** - Amount raised: $500,000 - Post-money valuation cap: $5 million Cap table after SAFE 1: | Stockholder | % Ownership | | ------------- | ---------------------------- | | SAFE 1 holder | `$500,000/ $5 million = 10%` | | Founders | `100% - 10% = 90%` | **Post-Money SAFE 2:** A year later, Company X raises another post-money SAFE with the following terms: - Amount raised: $1.5 million - Post-money valuation cap: $10 million Cap Table after SAFE 2: | Stockholder | % Ownership | | ------------- | ---------------------------------- | | SAFE 1 holder | 10% (remains unchanged) | | SAFE 2 holder | `$1.5 million / $10 million = 15%` | | Founders | `90% - 15% = 75%` | Note that after the second SAFE was raised, the previous SAFE holders were not diluted. The only party diluted was the founders. This is a key difference between pre-money and post-money SAFEs. **Series A:** - Amount raised: $5 million - Post-money valuation cap: $20 million Cap Table after Series A: | Stockholder | % Ownership | | ----------------- | -------------------------------- | | Series A Investor | `$5 million / $20 million = 25%` | | SAFE 1 holder | `10% * (100% - 25%) = 7.5%` | | SAFE 2 holder | `15% * (100% - 25%) = 11.25%` | | Founders | `75% * (100 - 25%) = 56.25%` | ## SAFE Dilution in Qualified Financing To summarize, the key difference between pre-money and post-money SAFEs has to do with dilution *with respect to other SAFE holders*: - **Pre-money SAFEs**: multiple rounds of pre-money SAFEs result in dilution for both founders and other pre-money SAFE holders. - **Post-money SAFEs**: multiple rounds of post-money SAFEs do not dilute the other post-money SAFE holders, only the founders. That being said, it is important to note that in *both pre-money and post-money SAFEs*, the SAFE holders' equity will be diluted when the startup raises a qualified financing round (like Series A). ## Structure and Key Terms in a SAFE Here, we will explore the key terms in a SAFE, including their significance for founders and investors (taken from Y Combinator's [Quick Start Guide](https://bookface-static.ycombinator.com/assets/ycdc/Website%20User%20Guide%20Feb%202023%20-%20final-28acf9a3b938e643cc270b7da514194d5c271359be25b631b025605673fa9f95.pdf)) - **Investment Amount**: The total capital provided by the investor under the SAFE agreement. It is crucial for founders to set the investment amount just right—not too high, to avoid giving up excessive equity, and not too low, to prevent running out of funds prematurely. The investment should be sufficient to reach the next major milestone, such as building a prototype, achieving product-market fit, or de-risking the product from a technical perspective. - **Valuation Cap**: The maximum company valuation at which the SAFE will convert into equity. This cap sets an upper limit on the conversion price per share, ensuring favorable terms for early investors if the company’s valuation significantly increases. The valuation cap rewards early investors by allowing conversion at a lower price per share compared to later investors, reflecting their higher risk. Founders must carefully set this cap to attract investment while managing dilution. - **Discount Rate**: A percentage reduction on the price per share at the time of conversion, compared to the price paid by new investors in a future financing round (like Series A). A higher discount rate means more shares upon conversion, increasing the SAFE investor’s ownership percentage. The discount rate compensates early investors for their risk by allowing them to purchase shares at a reduced price. Founders need to balance the discount rate to make it attractive to investors without causing excessive future dilution. - **Pro Rata Rights**: These rights allow SAFE investors to maintain their ownership percentage in future financing rounds by purchasing additional shares. This protects their investment from dilution. Granting pro-rata rights can attract investors who believe in the company's potential, but this also has the effect of diluting founders who have to reserve extra shares for these rights in future rounds. - **Most Favored Nation (MFN)**: SAFEs with a "Most Favored Nation (MFN) Provision" typically do not include a Valuation Cap or Discount Rate. Instead, these SAFEs allow the investor to amend their agreement to reflect the terms of any SAFEs issued later by the company that are more favorable to investors. This provision ensures that early investors are not disadvantaged if the company subsequently offers better terms to new investors. Some points to note about this provision: - *Amendment Rights*: If the company issues new SAFEs with advantageous terms, such as a Valuation Cap or Discount Rate, the MFN provision allows the investor to amend their existing SAFE to adopt these new terms. - *One-Time Amendment*: The MFN provision typically allows only one opportunity for the investor to amend their SAFE. Once the MFN is triggered and the terms are amended, the investor cannot amend the SAFE again based on future SAFEs unless those future SAFEs also include an MFN provision. - *No Cherry-Picking*: The investor cannot selectively choose favorable terms from various SAFEs. If the MFN is exercised, the entire SAFE is amended to match the new SAFE's terms in full, except for the purchase amount. - *Equity Financing*: If an equity financing event occurs before the SAFE is amended under the MFN provision, the investor will receive the same class of preferred stock as the new money investors at the same price. - *Liquidity Event*: In the event of a liquidity event before the SAFE is amended by the MFN provision, the investor is entitled to receive a portion of the proceeds equal to their original purchase amount. - **Conversion Trigger**: Specifies the events that will cause the SAFE to convert into equity, typically during a qualified financing round such as a Series A. Clearly defined triggers ensure both founders and investors understand when and how SAFEs will convert, usually tied to significant company milestones to ensure investors convert at a meaningful point in the company's growth. ### Lack of a Maturity Date Note that, unlike convertible notes, SAFEs do not have a *maturity date*, meaning that do not need to be repaid or converted by a specific deadline. For founders, this means having more flexibility in deciding when to raise a priced round for conversion. For investors, it means being comfortable with the long-term nature of their investment, as there is no fixed date for conversion. The lack of a maturity date aligns the investment more closely with equity rather than debt, focusing on the long-term growth potential of the company. ### Valuation Cap and Discount Rate Together SAFEs can include both a valuation cap and a discount rate. In such cases, these provisions are designed to provide favorable conversion terms for the investor, *but only one of them applies during conversion—either the valuation cap, or the discount rate*. This ensures early investors are adequately rewarded for their risk without allowing them to double-dip. For example, consider a SAFE with a $5 million valuation cap and a 20% discount rate: - If the next financing round values the company at $10 million, the valuation cap is more favorable, as it allows conversion at a $5 million valuation, giving more shares to the investor. - If the next financing round values the company at $6 million, the discount rate might be more favorable, as a 20% discount on $6 million results in a conversion price equivalent to a $4.8 million valuation. Thus, the investor benefits from whichever term—valuation cap or discount rate—provides a better conversion price, maximizing their equity stake. ### Discount, No Valuation Cap SAFEs can also be structured with only a discount rate and no valuation cap. This means the SAFE will convert into shares at a discounted price per share based on the next equity financing round. - The discount rate applies when converting the SAFE into shares of preferred stock in an equity financing. - In a liquidity event, the investor is entitled to receive the greater of: - A return of their initial investment amount, or - The amount they would receive if their investment had converted into common stock, calculated by applying the discount rate to the *fair market value* per share. **Note:** _Fair market value_ is different from the price per share that the company sells for (called _preferred price_) during the liquidity event. The fair market value is calculated based on an independent appraisal or an agreed-upon formula that considers various factors such as the company's financial health, market conditions, and comparable company valuations. This value reflects what the common stock would be worth in an open market transaction, independent of the negotiated price in the liquidity event. **Example:** Consider a SAFE with a 20% discount rate and no valuation cap: - If the next financing round values the company at $10 million and sets a price per share of $10, the SAFE investor would convert at $8 per share (20% discount), resulting in more shares compared to new investors. - At the time of a liquidity event, if the fair market value of the common stock is $5 per share, the SAFE investor's investment would convert to equity at $4 per share (20% discount on the fair market value). The SAFE investor's final return is calculated by multiplying the number of shares he received (at $4 per share) and the preferred price per share, ensuring they receive a higher return on their investment. ### Pro Rata Rights Pro rata rights allow SAFE investors to purchase additional shares in future equity financing rounds in order to maintain their existing ownership stake in the company. This prevents their ownership from being diluted by the issuance of new shares. #### How Pro Rata Rights Work In a SAFE, pro rata rights typically work as follows: - The SAFE investor is granted pro rata rights to purchase their pro rata share of new shares issued in an "equity financing" round that qualifies the SAFE for conversion into equity. - Pro rata rights terminate upon the initial equity financing closing, a liquidity event, or dissolution event. - Pro rata rights are optional in post-money SAFEs, granted via a side letter agreement rather than automatically included. We can calculate the pro-rata allocation required to be set aside for the SAFE 1 holder using the following formula: $ \text{Pro-Rata Allocation \%} = \frac{\text{Series A Investors \%}}{100\% - \text{SAFEs with Pro Rata \%}} - \text{Series A New Investors \%} $ So in essence, pro rata rights allow an investor to maintain their ownership level by having the option to invest more money in future financing rounds when the SAFE converts to equity. Founders must consider pro rata rights carefully during the SAFE fundraise. Otherwise, they may end up taking more dilution than anticipated in order to include all of the investors in the round. ## Example: SAFEs with Valuation Cap, Discount Rate, and Pro Rata Rights **Initial Cap Table:** |Stockholder|% Ownership| |---|---| |Founders|100%| **Post-Money SAFE 1:** - Amount raised: $500,000 - Post-money valuation cap: $5 million - Discount rate: 20% - Pro rata rights: Yes **Post-Money SAFE 2:** - Amount raised: $2 million - Post-money valuation cap: $20 million - Discount rate: 10% - Pro rata rights: No **Series A:** - Amount raised: $5 million - Post-money valuation cap: $20 million Conversion terms: - SAFE 1: Better to use $5 million valuation cap of SAFE 1 than the $16 million effective cap (after 20% discount rate on $20 million). - SAFE 2: Better to use $18 million effective cap (after 10% discount rate on $20 million) than the $20 million valuation cap of SAFE 2. $ \text{Pro-Rata Allocation \%} = \frac{\text{Series A Investors \%}}{100\% - \text{SAFEs with Pro Rata \%}} - \text{Series A New Investors \%} $ Series A Investors % = $5 million / $20 million = 25%. SAFE with Pro Rata % = 10% (Only SAFE 1 has Pro-Rata rights, not SAFE 2). $ \text{Pro-Rata Allocation \%} = \frac{\text{25 \%}}{100\% - \text{10 \%}} - \text{25 \%} = 2.77\% $ New ownership stakes after Series A with pro-rata rights exercised: | Stockholder | % Ownership | | ------------------- | ----------------------------------------------------- | | Series A Investor | `$5 million / $20 million = 25%` | | Pro-Rata Allocation | `2.77%` | | SAFE 1 holder | `10% (original SAFE) * (100% - 25% - 2.77%) = 7.23%` | | SAFE 2 holder | `15% (original SAFE) * (100% - 25% - 2.77%) = 10.83%` | | Founders | `100% - 25% - 2.77% - 7.23% - 10.83% = 54.17%` | Since only SAFE 1 was given a pro-rata right, the `2.77%` equity is given to the holder of SAFE 1, bringing their stake in the firm back to `10%` (`7.23%` + `2.77%`). These examples illustrate how different terms in post-money SAFEs, such as discount rates, valuation caps, and pro rata rights, affect the final ownership distribution after a qualified financing round. ## Conclusion SAFEs today have offered a streamlined and flexible alternative to traditional funding methods. From its inception by Y Combinator in 2013, it has continually evolved to meet the needs of both founders and investors. However, it's crucial for both founders and investors to thoroughly understand the terms and implications of SAFEs. The interplay between pre-money and post-money SAFEs, valuation caps, discount rates, and pro rata rights can significantly impact future ownership distribution and fundraising dynamics. Founders must carefully consider these factors when issuing SAFEs to ensure they maintain sufficient equity and control over their companies as they grow.