Most early stage start-up companies initially raise money from outside investors using convertible securities, such as convertible notes or Simple Agreements for Future Equity (“SAFEs”). These agreements allow the company to receive money from an investor in exchange for a promise to give the investor equity in the company at some future date, usually when the company issues preferred stock to investors in a later financing.
One of the most popular forms of convertible security is the SAFE. The SAFE was first used and popularized by Y Combinator, a start-up incubator located in the Bay Area, in 2013 in an effort to reduce the time and cost needed for its start-up incubator companies to raise small amounts of capital.
As simple as the SAFEs may appear, there are some things you should be aware of in issuing (as a company) or signing (as an investor) a SAFE, as well as some practical tips for you as you review and sign SAFEs as part of a company financing.
- Where can I get a copy of a SAFE I can use?
As the originator of the SAFE, Y Combinator publishes multiple forms of SAFEs on its website, and occasionally updates those forms. You can find Y Combinator’s forms of SAFEs here:
YC Safe Financing Documents | Y Combinator
There are some sites and services that may charge for using their form of SAFEs. You do NOT need to use these SAFEs and there is no reason to pay to use anyone’s form of SAFE.
Likewise, virtually all law firms (from small one person shops all the way up to the biggest, white-shoe law firms), use the YC forms (or a variant of those forms) and to that extent the SAFE forms are highly standardized.
- What are the different SAFE forms I’m seeing?
The YC site offers a few different forms of SAFEs. Currently, the main SAFE forms available on their site are:
SAFE with a Valuation Cap (no Discount)
SAFE with Discount (no Valuation Cap)
SAFE with MFN (no Discount, No Valuation Cap)
In addition, another common form of SAFE is a SAFE with Discount AND a Valuation Cap. Though no longer available on the YC site, you see this form floating around as well).
Which of the forms makes the most sense will depend on what you and your investors are willing to agree to. Also, in some cases, certain forms are considered more “investor” favorable and some are more “company” favorable.
- How Does a SAFE with a Valuation Cap work?
In a SAFE with a Valuation Cap (no Discount), a hypothetical “valuation” is agreed between the company and the investor which forms the maximum conversion price for the SAFE.
Example:
An investor invests $100K in a SAFE with a Valuation Cap of $1M.
When the SAFE converts, it will convert such that the investor will be entitled to 10% of the company ($100K out of the $1M valuation), prior to the dilution experienced by all investors in connection with the future equity financing itself. This will be true even if the company ultimately raises a future equity financing at a higher valuation (if the company raises at a lower valuation, the investor typically gets the better (lower) of the $1M valuation cap, or the actual valuation).
The benefit to an investor of a SAFE with a Valuation Cap is that it provides certainty to an investor as to exactly how much (on a percentage basis) of the company the investor is “buying” with their investment.
For the company, a valuation cap makes sense if the valuation cap is higher than the investors might pay for the preferred stock today. Using a SAFE with a valuation cap in that circumstance allows the company to earn a higher valuation (by securing a future financing at the higher valuation) but protects the investor from “overpaying” if no higher valuation is later achieved. A SAFE with a valuation cap can also make sense where all parties agree on the current valuation, but are not willing to do a full equity financing.
- How Does a SAFE with a Discount work?
In a SAFE with Discount (No Cap), an conversion value is NOT locked in. Instead, the valuation that the SAFE will convert into (and thus the number of shares and % ownership of the company that the investor will ultimately get) will be determined based on the valuation of the equity financing that the SAFE converts into, less a discount that is specified in the SAFE.
Example:
An investor invests $100K in a SAFE with a 20% Discount (No Cap).
When the SAFE converts, it does so in conjunction with an equity financing at a $1M valuation. If there were no discount, the SAFE would convert at the same valuation as the rest of the equity financing. However, with a 20% discount, the SAFE will convert at a $800K valuation (20% discount off of the $1M valuation).
A SAFE with a Discount (No Cap) can be more company favorable than a SAFE with a Valuation Cap (No Discount) in circumstances where the valuation cap that the investor would agree to is significantly lower than the likely valuation for the next financing. In addition, using a SAFE with a Discount (No Cap) avoids having to agree upon a specific valuation of the company, which is helpful if the parties aren’t able to come to a consensus as to what the right valuation is.
Finally, investors sometimes propose a SAFE with BOTH a Valuation Cap AND a Discount. In this case, the investor gets the best of both worlds – this type of SAFE converts at a valuation that is the lower of the valuation cap, and a discount to the valuation in the equity financing that the SAFE converts into. While no longer available at the YC site, it was not an uncommon form.
- What is the difference between a Post Money and Pre Money SAFE?
A SAFE with a post-money valuation cap ensures that an investor will be entitled to a certain % ownership equal to the amount of money invested divided by the post-money valuation cap. The investor is protected against all dilution, and the company’s equity holders (other than the holders of the post-money SAFE) will experience all of the dilution from the issuance of more SAFEs.
The SAFE with Valuation Cap example above assumed an investment of $100K at a $1M post-money valuation cap, resulting in 10% ownership for the investor, regardless of any other capitalization events.
With a pre-money valuation, the % ownership that investor will receive is not fixed, but varies based on the total amount raised through convertible securities. In the case of a $1M pre-money valuation cap, that $1M valuation is a floor, not a cap or ceiling. Additional amounts raised are “added” to the pre-money valuation “floor,” and the final valuation that the SAFE converts into will be the pre-money valuation plus the amount of all other SAFEs raised.
Example:
An investor invests $100K into a SAFE with a $1M pre-money valuation. At the time of conversion, a total of $200K was invested through SAFEs.
In this case when the SAFE converts, it will convert such that the investor will be entitled to 8.33% of the company ($100K out of the $1.2M valuation; the $1M pre-money valuation + the additional $200k in capital raised through SAFES). If additional SAFEs had been sold, the percentage ownership would have been lower, and if fewer SAFEs had been sold, the percentage ownership would have been higher.
A pre-money valuation SAFE is generally seen as more company favorable, as the SAFE investors share some of the dilution coming from additional capital investment.
Pre-money SAFEs are much less common as a result of YCs decision to stop publishing a pre-money form on their site.
- As long as it’s a YC SAFE and I know which form I want to use (eg Valuation Cap or Discount), I don’t need to worry about reviewing too closely, right?
People (whether companies or investors) will often talk about using the “YC SAFE”, but sometimes the simplicity of a SAFE (its only 2-3 pages) can be deceiving.
While it’s a short form, as noted above, there are different types of SAFEs (Valuation Cap, Discount, MFN, etc.). You will want to be sure you are using the right form of SAFE agreed upon by the parties.
In addition, the form of SAFE available on the YC site has changed over time. As such, a SAFE that might have been used a few years ago may be slightly different than a SAFE available on YC’s site today. You will want to be sure you and your investors are using the same form of SAFEs for your investors to avoid both confusion and/or the possibility that the SAFEs convert or are treated slightly differently between your investors.
- How are SAFEs different than Convertible Notes?
Unlike a convertible note or other debt instruments, a SAFE does not specify any interest or interest rate, and no interest accrues or is ever due.
In addition, unlike convertible notes, SAFEs do not have a maturity date. A typical convertible note will entitle the holder to demand either payback of the note, or conversion of the note into equity at maturity. However, for the standard YC SAFE, there is no maturity date specified, meaning that an investor cannot force payment or conversion of the SAFE into equity. In this way, SAFEs are more company favorable.
Finally, in some cases convertible notes or other debt instruments will also contain other protective provisions that benefit the investor holding the note or instrument, such as:
- information rights
- reporting obligations
- covenants that restrict what the company can do
- approval rights over certain actions of the company
- requirements that the company provide collateral to secure the obligations of the company under the note.
While a note may not include all of these provisions, a typical note will include some of these provisions. However, the standard YC forms of SAFE do not.
For these reasons, a SAFE is generally considered much more company favorable, and if given a choice to issue either a SAFE or a convertible note, it is generally in the best interest of the company to issue a SAFE.
- When would I use a SAFE vs a Convertible Note?
Generally speaking, a SAFE will be more company favorable than a convertible note, and therefore it is generally in the best interest of the company to issue a SAFE.
However, there may be instances where a company may not be able to issue a SAFE, usually in situations where an investor insists on receiving a convertible note rather than a SAFE. This may be especially true in cases where the investor is concerned about downside protection and is looking for a security interest in the assets of the company to protect against non-payment of the note, or would like information rights, covenants, or other provisions to ensure the company is not taking actions that may increase the risk that the note is not paid back.
In addition, once a company has raised money via a priced round, the use of SAFEs to raise subsequent capital is much less common, although some companies have still used SAFEs in those instances.
That said, especially with respect to West Coast private early/seed stage venture financings, SAFEs have become very common over the last 10 years and have been used for amounts ranging from a few thousand dollars to millions of dollars.
- As a company, what are things you should think of BEFORE issuing a SAFE?
While the ease of drafting, negotiating and issuing SAFEs have made them very popular for seed stage private financings, companies often forget that SAFEs are still securities that must either be registered, or fall under a specific exemption under applicable laws.
Most private companies looking to raise future venture financings will issue SAFEs in reliance of an exemption that only applies where there is no general solicitation for investors, and where all investors are “accredited.”
Before a company issues a SAFE, it should make a determination of whether an investor will be accredited. Although it can be tough to raise capital, to the extent an investor can’t meet the requirements of an accredited investor, the company should exclude that investor.
In addition, to ensure a company issuing a SAFE falls within typical securities exemptions, companies should be careful to avoid selling SAFEs through any form of general advertisement or solicitation.
- What are things I need to think about when filling in a SAFE?
SAFEs are incredibly short and easy to fill out, typically with just spaces for the date, the dollar amount being raised, the name of the investor, and depending on the type of SAFE, the valuation cap, or the discount rate.
However, there are a few things to be aware of that sometimes trip people up in filling out a SAFE form:
(a) Be sure you are using the right type of SAFE form as agreed upon by the company and investor(s). If you’re not sure, re-check the forms on the YC site or discuss with your attorney.
(b) Confirm who the proper investor/legal entity is that will be investing – this should be the same person or entity that is making the investment and expects to receive the shares of the company that result from the conversion of the SAFE. While sometimes that is a specific individual, more often it is an entity (and in many cases individual angel investors will have set up a specific LLC or other investment vehicle to make investments, so please be sure to ask or have the investor fill it out themselves).
(c) If the SAFE has a discount, note that the discount that is filled in the SAFE is usually expressed as a number that is 100% MINUS the discount % (e.g. a 20% discount would mean that 80% (not 20%) is entered into the SAFE, as that is the number that is used to multiple against the equity financing preferred share price to arrive at the correct conversion price for the SAFE).
(d) Close to the end of the form, the standard YC SAFE leaves a blank for the governing law – in many cases people miss this and forget to fill this in. Most companies raising money in the venture capital space are Delaware corporations, and so for most companies, specifying Delaware as the governing law makes sense. However, in certain instances, it may make sense to specify the state that the company resides in. That said, if you’re unsure, please consult with your attorney.
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