Introduction

If you’re picking up this guide, it’s a really exciting time in your life. You’ve likely taken a big risk to build something that you believe could have a huge impact. You’re trying to build out your minimum viable product and test it with customers to see if you have a product market fit. Congrats!

For more than a decade, I’ve worked with hundreds of early-stage founders to help them move from concept to scale. In that time, our firm has been legal counsel to startups in various industries from food to fashion, education technology to e-commerce, and wellness to Web3. I’ve worked with founders from the most elite schools and incubators, and with outsiders and underrepresented founders. I’ve learned a lot about raising capital along the way.

My goal here is to share that experience with you in this ultimate guide to the Simple Agreement for Future Equity (SAFE). By the time you finish this guide, you will understand the basics of a SAFE and be equipped to step into negotiations with investors with confidence.

I’m rooting you on and am here to support your fundraising journey if you need legal counsel.

Sincerely,

Kyle Westaway
Managing Partner, Westaway

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SAFE

What is a SAFE?

A Simple Agreement for Future Equity (SAFE) is a contractual agreement between a startup company and its investors (i.e., SAFE investor). It is an agreement where the investor’s investment is exchanged for the right to purchase preferred shares in the startup company when the company raises a future round of funding. The SAFE sets out conditions and parameters on when and how the capital would convert into equity. Unlike a convertible note, a SAFE does not accrue interest and does not have a maturity date.

SAFE was introduced by Y Combinator (the world’s preeminent startup accelerator) in late 2013. It was designed for early-stage startups and seed stage investors to raise capital quickly and simply. Since then, almost all Y Combinator startups have used SAFE in early-stage fundraising. Outside of the Y Combinator community, the SAFE has exploded in popularity within the startup community because it is founder-friendly, simple and efficient.

In 2013, the first version of the SAFE from Y Combinator was a “pre-money” SAFE. This worked fine when the size of funding rounds was smaller and when the SAFE immediately preceded a Series A round. As the popularity of the SAFE increased, and size and number of rounds increased, the pre-money SAFE became less ideal.

In 2018, Y Combinator released the “post-money” SAFE. What does “post-money” mean and why does it matter? We’ll dive deeper below, but in short, the SAFE investor’s percentage of ownership is measured after (post) all the SAFE investment is accounted for (which is its own round now) and before (pre) the new money in the priced round that converts and dilutes the safes (usually the Series A, but sometimes Series Seed). The most important element of this change is that founders and investors have a better ability to precisely calculate ownership percentage and dilution of each SAFE. This clarity is essential if founders want to scale their company while still retaining the appropriate ownership at each stage.

At any rate, the post-money SAFE has become the industry standard now. Almost every new deal going forward will use the post-money SAFE; the pre-money SAFE will fade into irrelevance. So, for the purposes of this guide, when we refer to a SAFE, we mean the post-money SAFE.

Y Combinator has drafted four versions of the SAFE. They are:

  1. SAFE: Valuation cap, no discount
  2. SAFE: Discount, no valuation cap
  3. SAFE: Valuation cap and discount
  4. SAFE: MFN, No valuation cap, no discount


Note that in the fall of 2021, Y Combinator removed number three, the SAFE: Valuation cap and discount from their website (without explanation). However, it remains a popular version of SAFE. The SAFEs are easy to use off the shelf with minimal amendment. However, investors and founders sometimes amend terms in SAFEs with the guidance of counsel to create their own variations.

Advantages

SAFE has been welcomed by the startup community for several reasons.

  • Fast and easy—SAFEs published on Y Combinator’s website are around six pages long. They are fairly simple and straightforward with fewer variables to understand and negotiate. This saves time in negotiation, which allows the transaction to move along in a faster and more efficient manner. It also saves associated costs in relation to the transaction.

  • No interest payment and maturity date. —SAFEs remove features in convertible notes that give startup founders headaches, such as interest payments and maturity dates. Using SAFEs mean founders no longer have to worry about keeping track of interest or asking investors for extensions when maturity dates approach. This allows founders to better focus on growing the company.

  • No repayment of principal. —SAFEs are founder-friendly and impose no obligation on the founders to repay the investment if the SAFE never converts into security. While this can be seen as a negative as the investors could be left with nothing, most professional seed stage investors understand the risks of investing in early-stage startups. However, SAFE is not suitable for investors who expect repayment of an investment should it fail.

  • High resolution fundraising. —A typical round of funding requires a lot of coordination to get investors aligned, signing documents and wiring money on a single close date. With the SAFE, startups can close with an investor as soon as both parties are ready to sign and the investor is ready to wire money. Y Combinator founder Paul Graham calls this high resolution fundraising.

Disadvantages

Despite all the convenience discussed above, SAFE is sometimes not so simple or safe.

  • No equity stakes. —Being a SAFE investor does not entitle one to the rights of a stockholder. SAFEs are not equity stake in the company, so SAFE investors are not protected under state corporate law or federal securities law. Instead, SAFE investors are entitled to a future equity stage only if certain triggering events occur. If the triggering event never occurs, a SAFE investor can be left with nothing.

  • Too easy. —Ironically, the main feature of the SAFE—its simplicity—is also a bug. Because it’s become so easy for founders to raise money on SAFEs, many founders raise a bunch of money without understanding the impact on the cap table. Then they have a rude awakening when the SAFEs convert, and they realize how much of their company they’ve given away and how much it has diluted them.

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Conversion

What happens to a SAFE at an equity financing?

The SAFE defines equity financing as a bona fide transaction or series of transactions with the principal purpose of raising capital, pursuant to which the company issues and sells preferred stock at a fixed valuation, including but not limited to, a pre-money or post-money valuation. Essentially, this is any future round of financing that is a priced round. Unlike the qualified financing in the convertible note, there is no minimum threshold.

Upon an equity financing, the capital that the SAFE investor invested converts into shares of preferred stock in the company. The shares will have the exact same preferences, rights and restrictions as the preferred shares of the new investors in the equity financing (new investors). So, founders should remember that when they are negotiating the terms of the investors in an equity financing, they are negotiating for the shares of the new investors as well as the SAFE investors. The number of preferred shares that the SAFE will convert into depends on whether there is a discount and/or a cap.

Now it’s time to do some math. Break out those calculators.

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Discount

The discount in a SAFE is used as a mechanism to address the higher risk of investment that SAFE investors take when investing in an early-stage startup. It is a discount off the price per share paid by new investors in the equity financing. The discount may range anywhere between 5% to 30%, with 20% being the norm.

For example, if the SAFE investors enjoy a 20% discount and the investors in the subsequent round of financing (new investors) purchase preferred shares at $1 per share, the SAFE investors would only pay $0.80 per share. The higher the discount rate, the more equity SAFE investors would receive for their investment.

The discount rate will be clearly defined in bold at the top of the agreement. The discount rate is written as 100% less than the discount rate. So, a 20% discount is written as 80% in the SAFE. A 10% discount is written as 90% in the SAFE.

Sometimes the discount alone may not be sufficient in protecting an early investor’s interest. Thus, some investors will use a valuation cap in SAFE to protect their interests in circumstances where the company is growing a lot more rapidly than expected.

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Valuation Cap

If the SAFE has a valuation cap, it’s typically the most heavily negotiated term. What is a valuation cap and why does it receive so much attention? A valuation cap 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 cap is $10 million and the new investors are investing in the company at a $20 million valuation, then SAFE investors will be paying half price for their shares relative to the new investors. (They can buy twice as many shares for their money as the new investors.)

Here’s the formula to calculate price per share with a valuation cap. The SAFE document refers to this as a safe price, so we’ll use that language below:

Safe Price = Valuation Cap / Company Capitalization

The company capitalization is calculated immediately prior to the equity financing and (without double-counting, in each case calculated on an as-converted-to-common-stock basis) includes:

  • all shares of stock (both common and preferred) issued and outstanding;
  • all (i) other SAFEs; (ii) convertible notes and other convertible debt instruments; and (iii) convertible securities that have the right to convert into shares of the company;
  • all (i) issued and outstanding stock options and (ii) promised options; and
  • unissued options in the stock option pool.

Founders should always keep future rounds in mind when they set a cap on their SAFE. The SAFE investors are taking a risk because they are investing earlier in the startup when there is increased uncertainty, so they should be rewarded for that early investment. But you probably don’t want them to be buying at half price of the new investors. If the cap is too low, founders risk giving up too much equity to the SAFE investors and diluting themself in the process.

If the valuation cap is set significantly lower than the pre-money valuation, the SAFE investor gets a heavy discount on the price per share as illustrated in the example above. This downward price adjustment can create the unfavorable outcome of diluting the founders’ share of the company and gives early-stage investors an oversized stake in the company.

Setting a valuation cap at an appropriate level requires understanding your company thoroughly and knowing the commercial value your business can bring. Founders should not treat a valuation cap as a valuation and should never let potential investors get away with that argument. A valuation cap is a projection of the maximum price (ceiling) at the subsequent round of equity financing rather than an actual pre-money valuation. Founders can also consider limiting the size of the seed stage financing to try to reduce the negative impact the valuation cap imposes.

The best-case scenario for founders is for the SAFE to be uncapped, but discounted. The discount allows the SAFE investor to be rewarded for their early risk. But it avoids the problem of trying to set some random value on the company, which could turn out to be incredibly high or low. Some investors insist that they will “never” invest in SAFEs without a valuation cap, as it is so common in pre-seed financing. However, the outcome usually depends on the bargaining power of respective parties. An uncapped note at the pre-seed stage might indicate that the company is attractive with some leverage in negotiations. This can help attract better investors in subsequent rounds of equity financing.

However, not every early-stage startup has investors knocking on its door. When faced with a valuation cap negotiation, founders should ensure that the valuation cap is set at an appropriate level, ideally at a level higher than the company could achieve if it were to do a priced equity round of financing.

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Valuation Cap Scenarios

If your SAFE has a valuation cap, there are only three possible outcomes at an equity financing.

SAFE valuation cap is higher than the equity financing valuation cap. Generally speaking, you want to see the valuation of your startup increase each round of financing. (Though a valuation cap is not technically a valuation, the market generally uses it as a proxy for valuation.) So, this scenario isn’t great from the perspective of founders showing growth in their company. However, from a SAFE conversion perspective, the valuation cap won’t come into play. If there is a discount, the SAFE investor will convert at the discount rate. If no discount, then the SAFE investor will convert at the same price as the new investors.

SAFE valuation cap is lower than the equity financing valuation cap This shows growth and progress for the company. The SAFE investor will convert at the SAFE valuation cap, unless there is a discount rate on the SAFE that would result in a lower price per share for the SAFE investor.

SAFE valuation cap is equal to the equity financing valuation cap. If the equity financing closes exactly at the SAFE valuation cap, then the SAFE investors will convert at the equity financing valuation and will realize no price preference compared to the new investors. In this scenario, if there is a discount rate on the SAFE that would result in a lower price per share for the SAFE investor, then the SAFE would convert at the discount rate.

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Most Favored Nation

What is an MFN?

The Most Favored Nation clause (MFN) allows early SAFE investors to receive as favorable terms as future SAFE Investors. The MFN-only SAFE has no discount or valuation cap. Instead, it gives the SAFE investor the right to participate on the same terms as future SAFE investors. The MFN clause acts as downside protection in the event that a more savvy or powerful investor is able to negotiate a better deal than they were able to negotiate.

For instance, a SAFE investor invested $20K into a company with an MFN SAFE. Three months later, a new investor invests $2 million on capped and discounted SAFE. The company has the obligation to inform the first SAFE investor about the new investment. If the first investor finds the terms of the new investor preferable, they may elect to amend their SAFE to the new terms.

A SAFE with MFN only (no valuation cap) saves the stress and challenges that entrepreneurs and investors face when negotiating the appropriate valuation cap while balancing the intent to protect early investors for the additional risks they take. However, it has to be adopted with caution. An MFN can reduce the potential for startups to attract funds. Having an MFN basically means the company gives up the opportunity to offer better terms to new investors, and this could make the company less appealing when attracting potential investments. Furthermore, it reduces the flexibility a company has when negotiating with new investors. You can foresee how this can heavily burden the company when attempting negotiations with new funds or trying to engage potential investors. Last but not least, disputes on MFNs can be complicated, and they often lead to lawsuits between founders and investors.

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Side Letter

A side letter is an agreement between the investor and the company that is supplementary to the main financing agreements—in this case a SAFE

The standard Y Combinator SAFE side letter includes Pro Rata Rights, which allows the SAFE investor the right, but not the obligation, to purchase its share of stock being sold in future financings. If a company is growing successfully, the Pro Rata Right prevents the SAFE investor from missing the opportunity to continue to invest and maintain their percentage of ownership. Pro rata rights are generally perceived as a fairly neutral term, and founders rarely push back on this term. However, from time to time, SAFE investors attempt to throw a laundry list of additional rights and preferences into a side letter. Founders should review the side letter carefully with counsel to understand the impact of each term.

In general, founders should try to avoid side letters mainly because the administrative burden of keeping track of who has which rights at conversion is challenging and overly complex.

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Conclusion

The SAFE is designed to get early investments into the company quickly and simply. Hopefully, this guide has helped you get a basic understanding of the terms of the SAFE. Though the guide is designed to educate, it is not legal advice and does not replace the need for counsel. Skilled counsel will help you understand which terms to negotiate and how to negotiate them. They will also ensure that the deal points on the term sheet are accurately reflected in the definitive documents.

I’m wishing you the best on your entrepreneurial journey. If I can help you with your SAFE or any other startup legal issues, please book a free consult.

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