A Simple Agreement for Future Equity (SAFE) is a contractual agreement between a startup company and its investors. It exchanges the investor’s investment for the right to preferred stock in the start-up company when the company raises a future round of funding. The SAFE sets conditions and parameters for when and how the capital will be converted into equity. Unlike one convertible notea SAFE does not accrue interest and has no maturity date.
SAFE was introduced by Y Combinator (the world’s leading startup accelerator) in late 2013. It is designed for early-stage startups and early-stage investors to raise capital quickly and easily. Since then, almost all Y Combinator startups have used SAFE in early stage fundraising. Outside of the Y Combinator community, the SAFE has become incredibly popular within the startup world for its founder-friendly nature, simplicity, and efficiency.
Y Combinator has produced four versions of the SAFE. They are:
- SAFE: Valuation limit, no discount
- SAFE: Discount, no valuation cap
- SAFE: Valuation limit and discount
- SAFE: MFN, no valuation limit, no discount
Note that Y Combinator removed number three, the SAFE: Valuation cap and discount, from their website in Fall 2021 (with no explanation). However, it remains a popular version of SAFE. The SAFEs are easy to use out of the box with minimal adjustments. However, investors and founders sometimes change terms in SAFEs with the guidance of counsel to create their own variations.
High-Resolution Fundraising: Benefits of SAFE Agreements for Startups
SAFE is welcomed by the startup community for several reasons.
● Quick and easy—SAFEs published on Y Combinator’s website are approximately six pages long. They are quite simple and straight forward with fewer variables to understand and negotiate. This saves negotiation time, making the transaction faster and more efficient. It also saves the associated costs in relation to the transaction.
● No interest payment and due date—SAFEs remove features in convertible notes that give startup founders headaches, such as interest payments and due dates. By using SAFEs, founders no longer have to worry about tracking interest or asking investors for renewals as the expiration date approaches. This allows founders to better focus on growing the company.
● No repayment of principal—SAFEs are founder-friendly and do not require the founders to return the investment if the SAFE is never converted to safety. While this can be considered a negative as the investors are left with nothing, most early stage professional investors understand the risks of investing in early stage startups. However, SAFE is not suitable for investors who expect a return on an investment if it fails.
● High resolution fundraising—A typical funding round requires a lot of coordination to get investors aligned, documents signed, and funds transferred on a single closing date. The SAFE allows startups to close with an investor once both parties are ready to sign and the investor is ready to transfer funds. Y Combinator founder Paul Graham mentions this high resolution fundraising.
Risks of SECURE
Despite all the convenience discussed above, SAFE is sometimes not that simple or safe.
● No equity interests—Being a SAFE investor does not entitle you to the rights of a shareholder. SAFEs are not equity interests in the company, so SAFE investors are not protected by state corporate law or federal securities laws. Instead, SAFE investors are only entitled to a future share phase if certain trigger events occur. If the trigger event never happens, a SAFE investor can have nothing left.
● Too easy—Ironically, the main feature of the SAFE — its simplicity — is also a bug. Because it has become so easy for founders to raise money on SAFEs, many founders raise a ton of money without understanding the impact on the dressing table. Then they are shaken awake when the SAFEs convert, and they realize how much of their business they have given away and how much it has diluted them.
SAFEs convert to equity financing preferred shares
The SAFE is converted to equity on the next round of financing, where the company sells preferred stock at a fixed valuation. Unlike qualified financing in the convertible bond, there is no minimum round size.
In an equity financing, the capital invested by the SAFE investor is converted into preferred stock in the company. The shares will have exactly the same preferences, rights and restrictions as the preferred shares of the new investors in the equity financing (new investors). Founders should remember that when negotiating the terms with the investors in an equity financing, they are negotiating the shares of both the new investors and the SAFE investors. The number of preferred shares into which the SAFE will convert depends on whether there is a discount and/or a limit.
The discount in a SAFE is used as a mechanism to address the higher investment risk that SAFE investors take on when they invest in an early-stage startup. It is a discount on the price per share paid by new equity finance investors. The discount can range from 5% to 30%, with 20% being the norm.
For example, if the SAFE investors get a 20% discount and the investors in the next funding round (new investors) buy preferred stock at $1 per share, the SAFE investors will only pay $0.80 per share. The higher the discount rate, the more equity SAFE investors would receive for their investment.
The discount percentage is clearly printed in bold at the top of the agreement. It is written as 100% less than the discount rate; for example, a 20% discount is written as 80% and a 10% discount is written as 90%.
Sometimes the discount alone is not enough to protect the interests of an early investor. Thus, some investors will use a valuation cap in SAFE to protect their interests in circumstances where the company is growing much faster than expected.
If the SAFE has a valuation limit, this is usually the most negotiated term. What is a valuation limit and why does it get so much attention? A valuation limit is the highest valuation at which the amount invested in the SAFE would be converted into shares. It is the maximum valuation that the SAFE investor will pay regardless of the actual valuation of the equity financing.
For example, if the SAFE valuation limit is $10 million and the new investors invest in the company at a valuation of $20 million, SAFE investors will pay half the price for their shares compared to the new investors. (They can buy twice as many shares for their money as the new investors.)
Founders should always keep future rounds in mind when placing a limit on their SAFE. The SAFE investors take a risk because they are more likely to invest in the startup when there is more uncertainty, so they should be rewarded for that early investment. But you probably don’t want them to buy from the new investors at half the price. If the limit is too low, founders risk giving up too much equity to the SAFE investors and diluting themselves in the process.
Which is Better for Founders: Discount or Limit?
In general, the ideal situation for founders is for the SAFE to be unlimited and discounted. This rewards the convertible bond investor for taking early risks. It also avoids the challenge of assigning an arbitrary value to the company, which can be too high or too low.
Some investors insist they will “never” invest in a SAFE without a valuation cap. However, the outcome depends on the negotiating position of the parties involved. In the pre-seed stage, an unlimited SAFE could suggest that the company is attractive and has some negotiating leverage, which could help attract better investors for later rounds of equity funding.
However, not all early-stage startups have investors eagerly waiting to invest. When negotiating a valuation ceiling, founders should ensure that it is set at a reasonable level – ideally higher than what the company could achieve if it did a priced round of shares.
An understanding of these terms will help founders work with their legal advisors to secure a beneficial deal for themselves and their team. Checking out this video learn more. For a deeper dive, read this guide.