When early stage founders are looking to raise money, they are often choosing between using Simple Agreements for Future Equity (SAFEs) or convertible notes. Our clients often ask what the difference is between the two and, though they are similar in some respects, SAFEs have some distinctive characteristics that you should be aware of. Key features of SAFEs are discussed below, and for a primer on convertible notes please check out this article.
A SAFE is an investment instrument that converts the holder’s value into equity of the issuer upon certain triggering events. As the name suggests, SAFEs were designed to be simpler, more streamlined, and an easier way for founders and investors to align quickly on an investment. Like convertible notes, SAFEs are popular in early-stage financings because they allow companies to raise money and investors to invest money without having to value the company before either party knows how much the company it is worth. Like convertible notes, they are sometimes also used for later-stage bridge financings as well.
While SAFEs originated in Silicon Valley, SAFEs (and other non-debt convertible securities with different names but similar terms) have also recently become popular in other markets, such as the UK and Singapore. This article mainly focuses on the US market, but the fundamental principles are consistent across most markets with an active venture capital scene.
Some Background on SAFEs
To understand how SAFEs work, it is helpful to have some context as to how they were created, and the issues they were designed to address.
In 2013, Startup accelerator Y Combinator first released SAFEs as an alternative to convertible notes, which are more investor-friendly in some respects. At the time the industry was flush with cash and founders found themselves with an unusual amount of bargaining power over financing terms. Instead of being bogged down with the negotiated terms of a Note, the idea was to create a short agreement that companies and investors could use that stripped away the debt-like features of convertible notes such as a maturity date and accruing interest, thereby simplifying early-stage financings for startups. SAFEs became widely popular, and in 2018, Y Combinator released a modified version of the SAFE with somewhat different terms, called the “post-money” SAFE (in contrast to the original “pre-money” SAFEs). We will discuss the difference between these versions below; for now, just know that the main difference between pre-money and post-money is the point at which the equity conversion is calculated upon an equity financing. This article focuses on the current post-money form of SAFE, except where we indicate otherwise.
Primary Features of SAFEs:
- Conversion. SAFEs convert into shares of the issuer’s stock upon a “triggering event,” which is usually the company’s first priced financing round. For most early-stage companies, that will be a Series Seed or Series A financing. At the time of the financing the SAFE will convert into equity of the issuer after taking into account any early-stage incentives (i.e., caps or discounts) relative to the price paid by the new (priced round) investors.
- Early-Stage Incentives. As with convertible notes, SAFE investors are typically provided with incentives relative to the priced round investors as a “thank you” for their early investment in the company.
- Discount Rate. SAFEs often include a discount rate (often between 10-25%) by which the price per share that the SAFE converts into is discounted compared to the price the priced round investors are paying. For example, if the Series A price per share is $1.00 per share, the SAFE investors with a discount rate of 20% will convert their investment into stock at $0.80 per share.
- 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, please see this article.
- Some SAFEs have both a valuation cap and a discount rate. If that is the case, the SAFE investor only converts under the provision that results in the greatest discount for the investor. (Sorry, early-stage investors, you do not get to take advantage of both the discount and the valuation cap.)
- Most Favored Nation (MFN). The MFN form of SAFE may be used when the company and the investor want to punt on conversion terms, knowing that the company is highly likely to set those terms with a future SAFE investor. This version of the SAFE provides that if future SAFE investors receive better terms (e.g. lower valuation caps or larger discounts), the MFN SAFE holders have the option of receiving those same terms.
- Pro Rata Rights. The Pre-Money SAFE contemplates a pro rata rights agreement which gives the investor a right to purchase its pro rata share of securities sold after the equity financing (to the extent the investor doesn’t receive that right under the equity financing documents), while the Post-Money does not. However, Y-Combinator has provided for a pro rata side letter which can be signed with specific investors in conjunction with the Post-Money SAFE. Pro rata rights simply allow the investor to purchase its pro rata share of the company’s stock being offered in the equity financing.
- Sale of the Company. SAFEs account for the scenario in which there is a liquidation event or the sale of the company prior to an equity financing round. In that scenario, the SAFE is generally treated like non-participating Preferred Stock (for an explanation of participating vs. non-participating Preferred Stock, please see this Cooley GO glossary entry).
Key Differences Between SAFEs and Convertible Notes
SAFEs remain outstanding until a conversion event occurs, or the issuer is acquired or liquidates. As a result, the investor and company do not need to spend time setting and extending maturity dates, and the company’s operational and funding-related decision-making isn’t affected by looming maturity dates.
- No Interest rate. This is the annual rate at which interest accrues on a loan, and accrued interest may need to be repaid, or add to the number of shares that the holder of an interest receives upon conversion. A SAFE has no accruing interest.
- No Maturity date. This is the date on which the issuer of a debt instrument may be obligated to repay the original investment amount and any accruing interest. A SAFE does not have a maturity date.
Pre-Money vs. Post-Money SAFE
The difference between the Pre-Money and Post-Money SAFE is that with a Pre-Money SAFE, the conversion into equity does not include the conversion of the SAFEs in its calculation. Consequently, a Post-Money SAFE does include the conversion of the SAFEs in the equity calculation. The money put into a company through SAFE investments is used to determine SAFE holder ownership. Because each SAFE’s conversion calculation is independent of each other SAFE, the Post-Money SAFE provides greater clarity as to how much of the company any given investor will ultimately own.
What Happens to a SAFE if there is no Conversion Event?
The dependence on a future conversion event highlights the risk to an investor of investing in a SAFE with the goal of ultimately owning an issuer’s capital stock. If a company fails to secure future equity financing or get acquired, then an investor’s SAFE will never convert into equity. The SAFE holder will be entitled to repayment in a dissolution of the company, although it’s likely there won’t be meaningful assets left to pay the SAFE holder in that scenario.
These are some of the primary features of a SAFE, which were designed to facilitate quick capital infusions while deferring additional variables for a later date. While SAFEs have some company-friendly features, it should be noted that SAFEs are not the right instrument for every deal or for every company, and there are other complexities in SAFEs that are beyond the scope of this article. However, if you decide to move forward with a SAFE transaction, you can find the primary financing documents available on Cooley GO (US forms prepared by Y Combinator here, and Singapore forms adapted by Cooley GO can be found here).