Part 1 : Demystifying SAFEs: A Comprehensive Guide

This is the first of 4 articles on SAFEs (Simple Agreement of Future Equity). In this series, we will take a look at what are SAFEs, and look at what are pre-money and post-money SAFEs and how do multiple SAFEs affect the founders dilution during SAFE conversion.

Introduction

In the world of startup financing, founders and investors often grapple with a multitude of instruments designed to balance risk and reward. Among these financial instruments are SAFEs, or Simple Agreements for Future Equity. SAFEs were designed by YC, a startup accelerator, which have taken off as one of the primary sources of funding in pre revenue stages where determining the valuation of a startup could be hard.

There are two main types of SAFEs: pre-money SAFEs and post-money SAFEs. In a pre-money SAFE, the investor’s ownership percentage is calculated based on the company’s pre-money valuation. In a post-money SAFE, the investor’s ownership percentage is calculated based on the company’s post-money valuation. Though YC has stopped issuing pre-money SAFEs, they are still used today but rarely.

In this article, we will take a deep dive into the concept of SAFEs. Lets look at what SAFEs are and how are they different from convertible notes

What is a SAFE?

A Simple Agreement for Future Equity (SAFE) is a financial instrument commonly used by startups to raise early-stage capital. SAFEs were introduced as a simpler, more founder-friendly alternative to traditional convertible notes and equity financing. They were pioneered by the influential startup accelerator, Y Combinator, and have since gained widespread adoption in the startup ecosystem.

The fundamental premise of a SAFE is straightforward: in exchange for an investment made today, the investor receives the right to convert their investment into equity in the startup at a later, predefined date or event. Unlike convertible notes, SAFEs do not carry an interest rate or maturity date, simplifying the terms and reducing administrative overhead.

How Does a SAFE Differ from Convertible Notes?

Convertible note is a short-term debt instrument where investor issues a loan that be converted to equity at a later date. Notes are debt instruments until the conversion event and hence as a debt instrument they can earn interest. The note also has a maturity date, after which the debt can be converted to equity or the investor can demand for the amount to be repaid.

SAFEs are simpler as they are not debt instruments hence they do not have interest and maturity date. Other than that SAFEs are similar to convertible notes as they both have valuation cap and discount rate.

Valuation Cap: It is the maximum valuation at which an investor’s investment will convert into equity when a future priced financing round occurs.

Discount rate: The percentage discount that the convertible note investors receive on the conversion price.

Introduction to Pre-Money SAFEs

Pre-Money SAFEs, as the name suggests, are a variant of the standard SAFE that comes into play before a startup undergoes a priced equity financing round. In a priced equity round, the startup establishes a valuation for itself, and investors purchase equity at a predefined price per share. However, in the early stages, startups often use SAFEs to secure funding without having a fixed valuation.

Share price of pre-money safes at the next financing round is calculated based on company capitalization (outstanding shares) at the time excluding the convertibles(Notes/SAFEs) and the valuation cap set.

Price = Valuation Cap/ Outstanding shares

Say, a startup raises a SAFE round of $1M at a $5M pre-money valuation cap and total shares outstanding at the time(founders + option pool + options issued) are 500,000.

During the next financing round the share price and the shares issued for SAFE investor can be calculated as:

• Share Price = $5,000,000/500,000 = $10
• Shares to be issued for SAFE 1 investor = $1,000,000/$10 = 100,000
• SAFE 1 holder Ownership after conversion = (100,000/(500,000+100,000))*100 = 16.67%

If another SAFE investor comes in at the same conditions as earlier SAFE investor, the number of shares issued for new investor is 100,000(Pre-money valuation/ Outstanding shares excluding convertibles)

• Outstanding shares = 500,000
• Shares to be issued for SAFE 1 investor = 100,000
• Shares to be issued for SAFE 2 investor = 100,000
• Ownership of SAFE 1 after conversion = Ownership of SAFE 2 after conversion = (100,000/(500,000+100,000+100,000)*100 = 14.29%

As we can see the ownership of pre-money SAFE holders also gets diluted when new SAFE(or Note) investors join. Hence the investors are unaware of their ownership before the financing round.

Introduction to Post-Money SAFEs

With Post-Money Safes, the conversion happens at a post-money valuation cap. The ownership valuation is calculated based on the amount invested and the valuation cap.

For example, if a startup raises SAFE round from an investor of $1M at $10M valuation cap, then:

• the ownership percentage of the investor at the time of conversion is 10%($1M/$10M)

If this startup raises another SAFE round at the same terms as the earlier investor, then

• Ownership of SAFE 1 after conversion = 10%
• Ownership of SAFE 2 after conversion = 10%
• Remaining shareholders + option pool = 80%

As we can see the ownership of existing convertible holders is not diluted when a new convertible is issued. Hence investors prefer post-money SAFEs as, unlike in pre-money SAFEs, their ownership upon conversion does not depend on the further convertibles issued.

Conclusion

SAFEs are a more founder-friendly financing instruments compared to Notes as they do not have maturity and do not trigger conversion at a maturity date. This takes away burden from founders to raise funding before the maturity date. Also founders do not have to pay interest on the principal.

Pre-money SAFEs favor founders as they tend to dilute all existing shareholders and all convertible (Note/SAFE) investors whereas in case of post-money SAFEs, all the dilution is borne by existing shareholders and not the convertible investors.

But Post-money SAFEs are more preferred as investors can know their ownership and do not have to wait until a financing round to calculate their ownership upon conversion (as a startup can raise many convertible rounds).