Financing often poses a significant challenge for startups. The process of securing funds from investors, who are willing to back a startup's vision and take a risk, can be complex. This article introduces Simple Agreement for Future Equity (SAFE), a type of investment contract designed to make the process considerably more straightforward...
SAFEs were introduced by leading startup accelerator Y Combinator as an efficient alternative to traditional convertible loan notes. They were designed to streamline the early-stage investment process and provide founders with greater flexibility. Unlike convertible notes, SAFEs are not loans, do not accrue interest and have no maturity date. Instead, they convert into equity usually during a subsequent priced equity financing round, e.g. Series A, by which time the company has scaled and can be valued.
In this article, written by the team at Déjà Partners, we focus on Post-Money SAFEs, which have gained considerable traction in early-stage startup financing over the last couple of years. Moreover, we will delve into the different scenarios that SAFEs cover, key features, a fully worked example and finally, how to account for SAFEs in a capitalisation table.
Scenarios Covered by SAFEs
SAFEs are designed to navigate multiple scenarios in a company’s life.
In the case of an equity financing round, SAFEs convert into the type of stock issued in that round, typically preferred stock. The amount of equity a SAFE investor receives depends on the terms of the SAFE, primarily the valuation cap and the discount rate.
During a liquidity event before the termination of the SAFE agreements, such as a sale of the company, SAFE holders have two options: they can either receive a pay-out based on their SAFE’s valuation cap (as if their SAFE converted to common stock immediately before the sale), or convert their SAFE into common stock and receive a pay-out based on the number of shares they now hold.
In a dissolution event, when a company shuts down without a sale or an equity financing, SAFE holders are typically out of luck. They are low on the list of creditors and usually, there is not enough money left over to pay them after all other obligations have been met.
Regarding liquidation priority, SAFE holders are inferior to debt holders and often equal to or slightly superior to common stock holders. The exact ranking depends on the terms of the SAFE and the company’s bylaws.
Finally, a SAFE can also terminate under certain conditions without converting into shares. If the SAFE includes a termination provision, it might stipulate that the agreement ends after a certain period, or if a specific event occurs.
Key Terms and Features of SAFEs
SAFEs often incorporate two primary mechanisms to reward early-stage investors for the risk they are taking: valuation caps and discount rates. However, the usage of each can vary depending on the specific agreement and negotiation between the investor and the company.
- Valuation Cap: The valuation cap is a mechanism that sets a maximum limit on the company’s valuation at which the SAFE will convert into equity. It protects investors from dilution in the case where the company’s value at the next financing round is very high. In this way, the valuation cap can be seen as a type of ‘discount mechanism’ because it potentially allows SAFE holders to convert their investment into equity at a price per share that is lower than what is paid by investors in the priced round.
- Discount Rate: The discount rate is a percentage reduction in the price per share paid by investors in the next financing round that SAFE holders receive when their SAFEs convert into equity. This feature is meant to reward the SAFE investors for the additional risk they took on by investing early.
In terms of prevalence, both mechanisms are common, but the valuation cap is more frequently used and is often considered the more important of the two mechanisms from the investor’s perspective.
This is because the valuation cap can often provide a greater discount on the share price than the discount rate, especially if the company’s valuation increases significantly.
However, some SAFEs include both a valuation cap and a discount rate, and the SAFE will convert at whichever method results in a lower price per share (and thus a larger ownership percentage) for the SAFE holders.
Other key terms include Participation rights and Most Favoured Nation clauses.
Participation rights allow SAFE investors to participate in future financing rounds to maintain their percentage ownership in the company.
The Most Favoured Nation (MFN) clause allows a SAFE investor to convert in the priced equity round on the terms of the lowest cap SAFE (or other most favourable terms, such as a discount) issued by the company to other SAFE investors.
Decoding Post-Money SAFEs and Navigating Valuation Caps
The newest version of Simple Agreement for Future Equity (SAFE), known as Post-Money SAFEs, offers a novel methodology for calculating valuation caps. Contrasting with the earlier models, these agreements leverage a “post-money” cap rather than the traditional “pre-money” cap. The term “post-money” refers to the valuation after accounting for other SAFEs, yet prior to the valuation of the company immediately following the priced equity preferred round.
An essential aspect of SAFEs lies in their conversion process. SAFEs agreed upon before a priced equity round undergo simultaneous conversion, causing dilution of the existing shareholders’ ownership, including the option pool, if applicable. However, it’s important to note that these SAFEs do not dilute each other during this process. Following the conversion of SAFEs, any future equity financing rounds would lead to the issuance of additional shares, causing dilution across all existing shareholders, encompassing those who initially held SAFEs.
Investment via SAFEs
Acme Inc. receives €2m of investment from two investors (Investor X and Investor Y). Investor X invests €500,000 via a post-money SAFE with a valuation cap of €4m shortly after company incorporation. Following a year of strong growth in the company, Investor Y invests €1.5m via a post-money SAFE with an increased valuation cap of €8m.
When these SAFEs convert in the future (triggered by a priced equity round such as Series A), they do not dilute each other; rather, they dilute the original shareholders (Anne and John) and the option pool.
Investor X’s Ownership Post Conversion:
Investor X’s investment of €500,000 at a €4m cap represents 12.5% of Acme Inc.
Investor Y’s Ownership Post Conversion:
Investor Y’s investment of €1.5m at a €8m cap represents 18.75% of Acme Inc.
Combining the stakes of Investor X and Y, the SAFEs represent 31.25% (12.5% + 18.75%) of Acme Inc.’s equity.
The founders’ share and option pool will therefore be diluted by the combined SAFEs percentage. So, we calculate 68.75% (100% – 31.25%) of the founders’ and option pool’s original ownership:
Founders’ Ownership Post Conversion:
(80% of 68.75%) = 55%
Option Pool Ownership Post Conversion:
(20% of 68.75%) = 13.75%
So, after the SAFE conversion, the ownership structure of Acme Inc. will look like this:
Founders (Anne and John): 55%
Option Pool: 13.75%
Investor X: 12.5%
Investor Y: 18.75%
The Priced Equity Round
Given the continued strong growth of the business, Acme Inc. decides to raise additional capital through a Series A priced equity financing round.
The company is successful in raising €3m at a fully diluted pre-money valuation of €15m.In this round, the price per share is determined by the pre-money valuation divided by the fully diluted capitalisation of the company. The fully diluted capitalisation includes all outstanding stock (common, preferred, etc.), all vested and unvested stock options, and any other convertible securities. In this case, it includes the converted SAFEs.
So, the percentage of the company that the Series A investors receive is calculated by dividing the investment amount (€3m) by the post-money valuation (pre-money valuation + investment amount). The post-money valuation is €15m (pre-money valuation) + €3m (investment) = €18m.
Therefore, the Series A investors receive €3m / €18m = 16.67% of the company.
This investment will dilute all existing shareholders including the founders, the option pool, and the SAFE investors.
Let’s calculate the dilution:
Founders’ Ownership Post Series A:
From the SAFE conversion, we know the founders own 55% of the company. After dilution by the Series A investment, their stake will be (55% * (1 – 16.67%)) = 45.83%.
Option Pool Ownership Post Series A:
The option pool had 13.75% of the company after the SAFE conversion. After the Series A dilution, this will reduce to (13.75% * (1 – 16.67%)) = 11.46%.
Investor X’s Ownership Post Series A:
Investor X owned 12.5% of the company after the SAFE conversion. After the Series A dilution, this reduces to (12.5% * (1 – 16.67%)) = 10.42%.
Investor Y’s Ownership Post Series A:
Investor Y owned 18.75% of the company after the SAFE conversion. After the Series A dilution, this reduces to (18.75% * (1 – 16.67%)) = 15.63%.
Series A Investors’ Ownership:
The Series A investors take a 16.67% stake in the company.
So, after the Series A round, the ownership structure of Acme Inc. will look like this:
Founders (Anne and John): 45.83%
Option Pool: 11.46%
Investor X (SAFE): 10.42%
Investor Y (SAFE): 15.63%
Series A Investors: 16.67%
Note: For clarity, this worked example assumes that the option pool is not topped up in the Series A round, which is a simplification as it is common for Series A investors to request this.
Managing SAFEs in Your Capitalisation Table
Finally, incorporating SAFEs in your cap table can be complex due to uncertainties surrounding their conversion into shares. Typically, if a valuation cap has been utilised in the SAFE, it serves as an estimation for conversion. However, it’s crucial to note that the actual conversion could occur at a lower valuation than the valuation cap. An important point to re-iterate is that when SAFEs convert in the cap table they do not dilute each other; rather, they dilute the original shareholders and the option pool. And remember, always use a spreadsheet to model your cap table!
Simple Agreements for Future Equity (SAFEs), specifically Post-Money SAFEs, offer a robust, flexible financing alternative that stands to revolutionise the landscape of early-stage startup investment. Their inherent simplicity, negotiability, and adaptability to diverse scenarios are key assets for both founders and investors alike. We have explored their functioning, key terms, valuation cap considerations, and have also presented a detailed worked example, emphasising the impact on the ownership structure of a hypothetical startup, Acme Inc. Though they introduce some complexity to capitalisation tables, a clear understanding of SAFEs allows startups to navigate the fundraising process with more confidence and clarity. We believe that SAFEs, when used with understanding and proper diligence, can lead to a more efficient and effective startup financing process, reducing complexities and tears along the way.
Thanks for reading.
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