The New Post-Money SAFE — What Founders and Investors Should Know
When YC first introduced the SAFE agreement in 2013, few expected it to become the de facto instrument for early stage investing. But the document has become all but ubiquitous, with some unintended consequences. To address the expansion and the shortcomings, YC just unleashed a revised document dubbed post-money SAFE. The changes are subtle — but have significant repercussions to founders and investors alike. Below are the major changes and my take on each.
1. The new SAFE valuation is post-money
What it means
The valuation cap in the new SAFE is post-money (as opposed to pre-money). For a company raising just one SAFE round, there’s effectively no repercussions: an investor willing to invest $2M on $8M pre-money is presumably willing to invest $2M on $10M post-money, with the same resulting ownership of 20%.
But things are different when multiple SAFE rounds are involved. Imagine the company raising an additional $2M on the same note a year later. Under the old SAFE agreement, the company will have effectively raised $4M on $8M pre / $12M post with investors owning 33.33% and founders 66.66%. Under the new agreement, the company will have effectively raised $4M on $10M post with investors owning 40% and founders 60%. Why the difference? Because in post-money agreement, subsequent SAFE investors dilute the founders but do not dilute the existing SAFE holders.
The mechanics here are the same as with priced round: if an investor and company agree on a pre-money valuation, then an investor’s resulting ownership is a function of their investment, the pre-money valuation and the overall round size. But if an investor and company agree on a post-money valuation, then an investor’s resulting ownership is a function of their investment and the post-money valuation irrespective of the round size. SAFEs have just become the latter.
My take
As YC’s blog post pointed out, the post-money SAFE has a significant advantage for both founders and investors — the ability to calculate precisely how much ownership of the company has been sold. But the new mechanism is a also boon to the early SAFE investors who are no longer getting diluted by additional SAFE rounds. How this change affects valuations for subsequent SAFE rounds remains to be seen¹
2. Investors no longer get pro-rata rights by default
What it means
The old SAFE granted SAFE holders a pro-rata right to protect their ownership. The new SAFE does not. Instead, company and investor can enter into a side letter granting the pro-rata right to investor. To make things simple, YC published a standard side letter on its website.
My take
Companies and investors will now negotiate pro-rata rights on a deal-by-deal basis. Investors writing a larger check will have more sway. In reality, this is already the case: even though previous SAFE holders were granted a pro-rata right, the right was often revoked in the Series A Investor Rights Agreement for investors not meeting a “major investor” criteria. The new mechanism is more in line with market realities.
3. The new pro-rata right takes place in the Series A, not the Series B
What it means
This is an important technicality that merits a deep dive. Let’s assume the SAFE converts in the Series A. Under the old SAFE, the SAFE holders — now holders of Series A Preferred Stock — were diluted by other SAFE holders and by the Series A, but were then allowed to purchase a pro rata portion of the Series B round to maintain their ownership. Under the new SAFE, if the investor signs the pro rata side letter, the investor is granted the right to maintain their ownership in the Series A round. In other words, an investor putting $2M on $10M post SAFE can effectively retain that 20% ownership through the Series A and possibly beyond.
My take
The old scheme granted investor pro rata rights one round removed. It didn’t make lot of sense. Not surprisingly, many investors would amend the SAFE agremeent with an explicit Series A pro-rata clause with a pre-defined ownership percentage. The new scheme is a more logical and transparent approach.
4. SAFE holders now more closely resemble equity holders
What it means
SAFE holders are now explicitly granted a number of rights similar to equity holders includeing the right to receive dividends (ICO proceeds anyone?) and the right to receive the same compensation choices in a liquidity event as equity holders. Additionally, the new SAFE introduces a new section, 1(d), that spells out the liquidation preferences following an acquisition in detail with SAFEs on par with preferred stock.
My take
This is sensible. As YC pointed out: SAFEs are “really better considered as wholly separate financings, rather than ‘bridges’ into later priced rounds.”
5. The new agreement is supposedly not modifiable
What it means
The new SAFE adds the following line: “This Safe is one of the forms available at http://ycombinator.com/documents and the Company and the Investor agree that neither one has modified the form, except to fill in blanks and bracketed terms.“
My take
Hallelujah! The S in SAFE stands for Simple. But attorneys constantly make edits to the document to justify their value add (and boost billable hours when none were needed). It’s one of my biggest pet peeves. And the resulting back-and-forth defeated the entire purpose of the SAFE.
The new SAFE attempts to address this issue by implying the document should not be modified — presumably without removing this paragraph first. Let’s hope it works. Somehow I suspect that company and investor counsel will simply drop this line and edit the SAFE as they please, or contribute their nuggets of wisdom in the pro-rata side letters instead. (A special place in hell will be reserved for those who edit the document without removing this line!)
6. Investor payout in a liquidity events is streamlined
What it means
Under the old agreement, if an acquisition took place before the SAFE converts, investors had the right to choose between receiving a cash payment equal to their investment amount or convert to common stock. Under the new agreement, investor automatically get the larger of their investment amount or the proceeds from the acquisition as if they had converted to common.
My take
Acquisitions taking place before a SAFE converts are often talent acquisitions — where the acquirer cares less about paying out investors and more about retaining management. Often it is the entrepreneur fighting with the acquirer to ensure investors are paid out. SAFE holders, not being shareholders, have little say in this transaction. The new mechanism is simpler and more transparent. But don’t expect it to alter this complex dynamic much.
7. A majority of SAFE holders can now amend the SAFE agreement for everyone
What It means
The old SAFE agreement could only be amended upon the written consent of investor. The new SAFE allows amendments by written consent from a majority of SAFE holders. There are some boundaries: the company must solicit the consent of every investor (even if consent is not granted), the Purchase Price may not be amended, and all investors must be treated in the same manner in the amendment.
My take
There are legitimate reasons to amend the SAFE: just last month I experienced a case where the founder incorrectly filled out the discount rate as 10% as opposed to 90%. In another instance, a founder merged two SAFE documents and in the process dropped the cap clause making it effectively an uncapped note. To amend these SAFE, founders had to get everyone’s consent which was no simple task. This clause makes it easier for founders to amend the SAFEs.
But the new clause also allows a majority of SAFE holders to enforce substantial changes on all the holders — including the actual cap. When companies struggle, it could be used by larger investor to drag-along smaller investors into accepting punitive terms.
8. Non-accredited investors are really not welcome
What it means
The old SAFE stipulated that the investor must be an accredited investor under Rule 501 of Regulation D of the securities act (which defines an investor, among other things, as having $1M in assets or $200K in income) But it never spelled out the repercussions. The new agreement explicitly grants the company the right to void the SAFE and return the Purchase Amount if the investor is not accredited.
My take
SAFEs have effectively become equity. Requiring participants to be accredited investors makes sense. And for Bay Area residents, $200k is barely enough to pay rent let alone invest in startups.
Conclusion
The first version of a new invention often resemble their predecessors with some awkwardness— the first automobile looked like a horsecarriage with an engine. Similarly, the first SAFE resembled a convertible note. It had complex pre-money conversion math. It talked of termination and expiration — even though there was no mechanism for expiration. It was meant as a bridge instrument and it read like one.
The new SAFE has matured into its own isntrument. Its emphasis on transparency should be lauded. And, while not perfect, it’s a welcome upgrade on many fronts to a document that has quickly become the standard in the industry. YC seems to have followed its own advice: build something people want. Then make it a little better!
Footnote 1: Detailed calculation comparing pre-money and post-money SAFE conversion and their impact on valuation
Imagine a company that has issued two SAFEs
- A $2M SAFE with a cap of $8M pre (old SAFE)/ or $10M post (new SAFE),
- A year later, the comapny would like to raise an additional $3M SAFE. The company has made progress and would like to increase its cap to $12M pre (old SAFE)/ or $15M post (new SAFE).
Let’s assume the company has 100 shares in its cap table held by the founders.
Under the old, pre-money SAFE agreement, the first SAFE receives 20% of new capital, or 25 new shares [25 new shares out of 125 total shares is 20%]. The second SAFE receives 20% of new capital, or 25 new shares as well. But the investors will dilute each kther: they each end up with 25 out of 150 total shares or 16.67%. The founders will end up with the remaining 100 out of 150 shares or 66.67%
Under the new, post-money SAFE agreement, the company will issue 40% of total new equity, which is 66.66 new shares [66.66 / 166.66 = 40%]. Each investor will receive 33.33 new shares and ends up with 20%. The founders will end up with 100 out of 166.66 shares or 60%.
What if the founders want to maintain their ownership at the same level held in the pre-money world (66.67%)? The founders can only issue 50 new shares. Because under the post-money SAFE later investors don’t dilute early investors, the first investor is getting 20% of the company, or 30 shares. The second investor can only get 13.33% of new equity (or 20 shares). Founder can either raise less money at the same valuation ($2M on $15M post = 13.33%), or raise the $3M at a substantially higher valuation ($3M on $22.5M post = 13.33%). How founders and later SAFE investors work this out remains to be seen!
Footnote 2: you can view the actual redline comparing both documents here
