New companies looking to raise money have several options. Issuances of common stock, preferred stock, and convertible notes are all on the table. Here, we talk about one of the newcomers to the game of startup finance — the Simple Agreement for Future Equity (SAFE).
Mom…Where Do SAFEs Come From?
The SAFE was invented in 2013 by Y-Combinator, a high-profile tech accelerator in Silicon Valley. Unlike common stock, which is centuries old, the SAFE is a young whippersnapper of a financial instrument! SAFEs have become popular in recent years due to their simplicity and relatively low legal costs.
Also, SAFEs have nothing to do with valuable-storing metal boxes. I was spending too much time finding an image for this article and decided it was time to move on with my life.
How Do SAFEs Work?
Let’s dive into the nuts and bolts of how startups can use SAFEs to raise money.
The Investment
An investor — sometimes referred to as an “Angel Investor” or a “Seed Investor” — will write your company a check in exchange for a SAFE. SAFEs are typically offered only to sophisticated or accredited investors in accordance with Regulation D private placements like Rules 506(b) and (c).
Conversion Rights
As you might imagine, investors aren’t just shelling out money out of the goodness of their hearts. What’s in it for them?
A SAFE investor receives the right to convert his or her SAFE into equity of the company at a discount. Remember, the last two letters in “SAFE” stand for “future equity.”
When Can a SAFE Investor Convert to Equity?
Typically, the holder of the SAFE can convert upon the earlier of two events:
- A “qualified financing” — usually a preferred stock offering to a venture capital firm
- A “corporate transaction” — usually the sale of the company
So, upon events like (i) a Series A Financing, (ii) a sale of substantially all of the company’s assets, or (iii) a merger, SAFE investors get the option to convert their SAFE into equity at bargain prices.
What Kind of Equity Does the SAFEholder Get?
Typically, the holder of a SAFE gets the right to convert into the same securities that are sold in the qualified financing.
So, if the next qualified financing involves a fancy venture capital firm negotiating Series A Preferred shares, the SAFEholder would get to convert their SAFE into those shares. In some cases, a SAFE investor may have the right to convert into common stock.
How Much of a Discount Does the Safe Investor Get?
This is where all the action happens. SAFEs have two concepts that determine the ultimate discount for SAFEholders: the discount rate and the valuation cap.
The discount rate is pretty straightforward. Essentially, the SAFEholders get a discount on the shares offered in the qualified financing. A sale on Series A Preferred stock! SAFE investors can expect to receive a discount of anywhere from 10-30%.
The valuation cap sets a ceiling on the pre-money valuation at which SAFEs can convert into preferred stock. This protects SAFE investors from ending up with a pitiful percentage of the company if the Series A round has a sky-high valuation. Valuation caps tend to range between $3-10 million.
The SAFEholders typically convert to preferred stock at the lesser of the price calculated based on the discount and the price calculated using the valuation cap.
An example will help.
Example Conversion of a SAFE to Preferred Equity
Let’s assume the following:
- You have 10 million shares of common stock, all of which are issued and outstanding
- You have $500,000 of SAFEs outstanding
- Discount Rate: 20%
- Valuation Cap: $5 million
- A venture capital firm values your company at $6 million (pre-money) for your Series A round
To determine the Series A price per share, divide the valuation by the number of shares. So, $6 million divided by 10 million shares is $0.60 per share. This is how much your stock is worth, according to the venture capital firm. Simple enough.
A 20% discount on $0.60 results in a $0.48 share price using the discount rate method (0.60 * (1 – 0.8)).
On the other hand, the valuation cap method results in a share price of $0.50 per share. To get this figure, divide the valuation cap ($5 million) by the total shares outstanding (10 million).
Here, the share price using the discount rate is lower, so the SAFEholders get to convert into the new Series A Preferred stock at just $0.48 per share — 20% less than the venture capital fund leading the Series A round pays.
Do SAFEholders Have to Exercise Their Conversion Rights?
In some cases, holders of SAFEs might have the right to receive a return of their investment (or a multiple of the investment) instead of converting into equity.
For example, an investor may get to choose between (i) a 1.5x equity multiple ($150,000 on a $100,000 investment) or (ii) a discount on Series A Preferred stock, as discussed above.
Liquidation Rights
In addition to conversion privileges, SAFE investors often have the right to recoup their initial investment before holders of common stock. So, a SAFEholder who invested $100,000 would get his or her $100,000 back before the founders would split up the assets upon a dissolution or winding up of the company.
Do SAFEs Have Protective Provisions?
Venture capital firms usually negotiate special rights when they invest in startups.
As described in my article on Series A financings, common protective provisions include:
- Vetoes over major decisions
- Representation on the board
- Price protection
- Rights of first refusal
- Inspection rights
While some SAFEholders may negotiate for protective provisions, a typical SAFE doesn’t extend these rights to investors.
How Do SAFEs Compare to Convertible Notes?
SAFEs and convertible notes are quite similar. Both typically convert into preferred equity at a discount and enjoy a liquidation priority over holders of common stock.
However, convertible notes, unlike SAFEs, accrue interest and mature at a specific date. These extra features give noteholders additional leverage to negotiate better terms if a qualified financing hasn’t taken place before the maturity date of the note.
For example, let’s say two-year convertible notes were issued in March of 2019. However, the company still hasn’t closed on a Series A financing by March of 2021. Convertible noteholders technically have the right to demand payment of the principal and interest on their notes. In practice, noteholders don’t demand payment. Instead, they use the maturity date as an opportunity to renegotiate the discount rate and/or valuation cap.
SAFEs, on the other hand, don’t have a maturity date and therefore don’t usually experience such issues. As a result, many founders prefer SAFEs to convertible notes.
Need Help Raising Money for Your Startup?
If you’re setting up a new business or starting the fundraising process, working with a knowledgeable attorney can help you avoid common startup pitfalls. If you want to learn more about startup financing, reach out today!