What are SAFEs? A simplified, (very) deep dive
Marc Hoag via Midjourney
This is educational material and does not constitute legal advice nor is any attorney/client relationship created with this article, hence you should contact and engage an attorney if you have any legal questions.
Introduction: The Rise of SAFEs in Startup Financing
Startups are fueled by innovative ideas and a drive for success, but they also require capital to take off. Traditionally, entrepreneurs have used equity financing rounds (“priced rounds” like “Series A”) or convertible notes to secure this much-needed funding. However, Simple Agreements for Future Equity (SAFEs) have emerged as a compelling alternative. This article aims to demystify SAFEs, outlining their features, advantages, complexities, and practical considerations.
What Are SAFEs?
The Basics
A SAFE is an investment agreement that promises future equity in a company in exchange for immediate investment. Designed as a simpler alternative to convertible notes, SAFEs offer a streamlined process that benefits both founders and investors. Unlike convertible notes, SAFEs are not debt instruments, eliminating complexities such as interest rates and maturity dates.
What’s the Difference Between SAFEs and “Priced Rounds”?
A “priced round” is the more typical “Series A” investment with which you’re probably more familiar. In a priced round like a Series A, investors put money in a startup in exchange for immediate equity at a price per share at an agreed upon company valuation.
With SAFEs, the investment is in exchange for a future promise of equity a discount relative to future investors, so the founders don’t part with equity right away. Simply put, the investors are deferring their equity to a future date in exchange for better terms. By getting in at a lower valuation, this means they get a larger piece of equity pie of the startup.
Origin and Evolution
SAFEs were introduced in 2013 by startup accelerator Y Combinator to simplify early-stage financing. They gained widespread popularity and underwent revisions in 2018, leading to the "post-money" SAFE, which is now the prevalent form (as opposed to “pre-money SAFEs”).
Key Features of SAFEs
Conversion Mechanism
As discussed above, the equity in exchange for SAFE investors’ early investments is deferred to a future date. SAFEs convert into company shares during a "triggering event," usually the first priced financing round such as a Series A. The terms often include early-stage incentives like valuation caps or discount rates, favoring the early investors.
Valuation Cap and Discount Rate
A valuation cap sets the maximum company valuation at which a SAFE converts, providing a safety net for investors. The discount rate, usually between 10-25%, allows SAFE holders to convert their investment at a rate lower than that of priced-round investors.
By way of example, if a Series A investor comes in at, say, a $10M valuation, a 20% discount to the SAFE investors mean that the SAFE investor would get in at $8M. This means that if the SAFE investors put the same $1M in as the Series A investors, the SAFE investor would control $1M/$8M = 12.5% of the startup, while the Series A investor would own just $1M/$10M = 10% of the startup.
Most Favored Nation (MFN) and Pro Rata Rights
Some SAFEs include an MFN clause, which ensures that if future SAFE investors get better terms, existing SAFE holders can opt for those terms as well. Pro rata rights, more common in pre-money SAFEs, allow investors to maintain their ownership percentage in future financing rounds.
Liquidity Considerations
In the event of a company sale or liquidation before equity conversion, SAFEs are generally treated like non-participating Preferred Stock, specifying the order in which investors are paid.
Anatomy of a SAFE
The paperwork for a SAFE investment is relatively succinct, and is made up five main sections, of which, the last three are mostly just legal boilerplate.
Section 1: Events: This section serves as an "instruction booklet," detailing how SAFEs convert or terminate under various scenarios like equity financing, company sale, or dissolution.
Section 2: Definitions: Key terms like "Company Capitalization" are defined here for clarity.
Sections 3-5: These sections cover legal requirements and representations from both the company and investors, including the status of the company and accreditation of investors.
Practical Considerations
Dilution and Cap Table
Understanding dilution is crucial. Founders must track how much equity they've promised to sell in SAFEs to accurately assess their ownership stake. This will be examined in thorough, granular detail further below.
Pre-Money vs. Post-Money SAFEs: What's the Difference?
Pre-Money SAFEs
In pre-money SAFEs, the SAFE investor's money is not included in the company's pre-money valuation. This means that when SAFEs convert into equity, the conversion price is determined by the pre-money valuation of the latest financing round. While this seems straightforward, it can create complexity when calculating dilution, especially if an option pool is being set aside for future employees.
Pros:
May be simpler to negotiate initially
More advantageous for founders when raising small amounts
Cons:
Dilution calculations can be more complex, especially if other elements like option pools are involved
May lead to less clarity about the percentage of the company owned by SAFE holders until a priced round occurs
Post-Money SAFEs
Post-money SAFEs include the amount invested in the SAFE when calculating the ownership percentage. This offers better clarity for both investors and founders, as it specifies exactly what percentage of the company the SAFE investor will own after the next financing round.
Pros:
Easier for both parties to understand ownership percentages immediately
Simplifies dilution calculations, making it easier to forecast ownership stakes after future rounds
Cons:
Generally less advantageous for founders, particularly when raising larger amounts
May be more complex to negotiate if coming from a background of using pre-money SAFEs
Why Post-Money is the Way to Go
While both types of SAFEs have their merits, post-money SAFEs are generally easier to manage and provide greater clarity on ownership stakes. This can be particularly advantageous for startups that anticipate multiple rounds of funding, as it simplifies the cap table and makes it easier to forecast the dilution effect of future financings.
This kind of clarity is invaluable in the fast-paced startup environment, where ease of execution and understanding can save both time and money.
Different Flavors of SAFEs
SAFEs come in various forms, like those with discount rates instead of caps, or uncapped SAFEs (unusual) with MFN clauses. The choice depends on the specific negotiation points between the investor and the company.
⚠️ SAFE Dilution Calculator: How Do SAFEs Dilute Founders’ Equity?
If there’s one section you read, it should be this.
To understand the math behind SAFEs, let’s walk through a scenario that spans the four stages of a typical SAFE investment round:
Company formation / incorporation
Post-money SAFE investors
Hiring (option pool)
Priced round (Series A investors & enlarge option pool)
These examples are taken from Y Combinator’s fantastic lecture video which you can and should watch here; as a reminder, the SAFE was created by Y Combinator in 2013.
Part I: Incorporation
We have two founders, F1 and F2. They launch a startup together called NBT Inc., (that’s “Next Big Thing”), and they agree to split their ownership 50/50. This means they each own 50% of the startup’s equity in common stock.
For math simplification reasons that will become apparent later, the total number of common stock shares issued at the time of company formation is an admittedly random-sounding 9,250,000 shares, with 4,625,000 going to each founder. (Strictly speaking, let’s assume they’re “restricted stock” since they’re subject to a typical vesting schedule of four years with a one year cliff.)
Part II: The Post-Money SAFE
So now F1 and F2 agree to raise money from two investors (SAFE Investor A and SAFE Investor B) in a post-money SAFE.
SAFE Investor A joins first with $200K. It’s early days for the startup, and it’s agreed that NBT should be valued at $3.8M. This means the post money valuation = pre-money valuation + money raised, i.e., $200K + $3.8M = $4M.
From this, we can determine that SAFE Investor A’s future ownership is equal to their investment amount divided by the post-money valuation, or $200K / $4M = 5%.
SAFE Investor B joins the party later — let’s say six months later — but brings in a larger $800K check. At this point, six months in, NBT is doing really well, hence it’s agreed that it should be valued at $7.2M, or a post-money valuation of $800K + $7.2M = $8M.
As before, this means that SAFE Investor B will own $800K / $8M = 10% of NBT.
So between the two of them, SAFE Investors A and B together will a total of 5% + 10% = 15% of NBT. This means, obviously, that the Founders’ equity will shrink from 100% to 85% once the SAFE converts and therefore, that their ownership will reduce to 85% / 2 = 42.5% each.
You will notice we keep speaking in the future tense regarding the SAFE Investors’ equity. This is because, if you remember, the whole point of a SAFE is that the equity doesn’t actually materialize for the investors unless and until a priced round like Series A takes place. Hence, the 15% take by the two SAFE Investors is symbolic, and not yet practical.
Note that SAFE Investor B does not dilute SAFE Investor A; only the original shareholders, in this case the Founders, get diluted.
Part III: Hiring
So now things are really swimming along nicely, and Founders are ready to make their first hires for NBT. Beyond mere salary, Founders want to reward the first employees with some equity in NBT; this is typical in most if not all startups.
In order to make sure there are shares available for the new hires, a plan is agreed to set aside an option pool with 750,000 shares; from this pool, 650,000 will be issued to hires, and 100,000 will remain available for future uses.
This obviously changes the cap table because it is an issuance of 750,000 additional shares; this then brings the total number of fully diluted shares (issued shares + option pool) to a nice round 10,000,000 common stock shares. (Now you understand why we started with that seemingly random figure of 9,250,000 shares earlier.)
So we’ve just added 750,000 common shares to the pot which reflect 7.5% of the total 10,000,000 shares; the balance (i.e., 100% - 7.5%) is what’s now left for the Founders, or 92.5%, or 92.5% / 2 = 46.25% each.
To be clear, the Founders’ 92.5% ownership has decreased from 100% because the new option pool has increased the total number of shares from 9,250,000 to 10,000,000; their ownership doesn’t include any of the options. So in a sense, our Founders’ 92.5% ownership is “the new 100%.”
But because our SAFE Investors (will eventually) collectively own 15% due to their investments, our Founders will actually have 85% (as mentioned above) of this new 92.5% , or 78.625%., with 39.3% to each Founder, for 3,635,250 common shares each.
So the founders have gone from a 50/50 ownership split at company formation, down to 46.25% split after the option pool was created, and they will eventually go down to 39.3% once their SAFE Investors’ shares convert in the future when they raise a Series A.
Part IV: Priced Round
Now let’s imagine a year has passed, and NBT, Inc. is really taking off. The $1M investment from the two first investors’ SAFE rounds has been put to great use and NBT is finally ready to raise its first “priced round,” a Series A, at a $15M pre-money valuation. This will be the anticipated “trigger” event that causes the SAFE Investors’ shares to convert so they realize their equity at last.
The total raise they're seeking in this Series A is $5M; hence the post-money valuation is $15M + $5M = $20M.
💡 Note that this is a markedly higher valuation than the $4M and $8M valuations for SAFE Investors A and B respectively. Again, this is the whole point: SAFE Investors A and B took greater risk by (a) investing early and (b) deferring the realization of their equity in exchange for more favorable terms, i.e., a lower company valuation.
This $5M in the Series A round will be split between a Lead Investor putting in $4M, with the balance coming from other smaller investors.
This means that Lead Investor will get $4M / $20M = 0.2 = 20% equity in NBT.
The remaining investors will get $1M / $20M = 0.05 = 5% equity.
At this point, there’s a negotiation by the Series A investors to further increase the option pool for more future hires. And yes, as before, this will further dilute things both for our Founders and also for our SAFE investors.
So how is the cap table updated at this point?
First we need to understand a distinction as between outstanding shares and any shares that are preserved in the option pool for, say future hires.
The outstanding shares are the sum of (a) the founders’ stock and (b) the options issued.
Not included in the outstanding shares are the options available.
We can now calculate the fully diluted shares as all of these, i.e., the sum of the outstanding shares (founders’ stock and options issued) + any shares reserved under the option pool.
So using our numbers above gives us the 10,000,000 total shares (9,250,000 founders’ stock + 650,000 options issued + 100,000 options still available).
As mentioned previously, we know that Lead Investor has $4M / $20M = 20% equity in NBT while the following investors have $1M / $20M = 5% equity.
Yet again, the whole point of SAFEs in the first place is precisely that they are a present day investment of cash for a future promise of equity in exchange for a discounted company valuation to the investors’ benefit. Hence the contrast with standard priced rounds like Series A which give up equity at the same instant that the investment is made, albeit at a higher company valuation to the founders’ benefit.
To be clear, until this point, our Founders have not yet actually given up any equity to their first SAFE investors; rather they’ve merely promised them some future equity transfer when they raise their first priced round, i.e., the Series A.
So now the Series A round has occurred, and three things happen that we shall discuss below in extremely granular detail:
SAFEs convert: The SAFEs’ conversion into equity is triggered (i.e., this is that future “trigger event” we contemplated previously)
Option pool: The option pool is increased as agreed
Series A investment: The new Series A investors actually write their check and invest and receive their appropriate number of shares at the freshly calculated share price
So let’s go through these three steps one by one.
(1) The SAFEs’ conversion into equity is triggered
The first thing to understand is that our SAFE investors do not just get some allocation of mere common stock; rather, they get preferred stock which basically means they get preferential treatment at future stock transaction events such as mergers, sales, and other liquidity events, in priority above the founders who hold just common stock.
So what we need to do now is to calculate how many of these preferred shares the SAFE investors will collect.
From the beginning of this exercise we know that SAFE Investor A gets 10% and SAFE Investor B gets 5%; so together they will get 15% of NBT, Inc.
This is where things get a bit complicated and not at all intuitive.
We know that there are 10,000,000 total diluted shares. But instead of representing 100% of the whole, this now represents 85% of the whole since we must take away the SAFE investors’ 15% take (we discussed this previously). So we can now calculate the new percentage ownership of our Founders’ common stock, the options issued, and the options available.
As you recall, our Founders had 9,250,000 common shares which represented 92.5% of 100% of the company following the issuance of the 750,000 options; but now since 15% has just been taken by the SAFE investors, our Founders now have 92.5% of the 85% remaining of the company, or 0.925 x 0.85 = 78.62% of the company.
Likewise, the options issued — all 650,000 of them — which previously represented 6.5% of all common stock now represents 6.5% of 85% = 0.065 x 0.85 = 5.53%. And the options available — previously 1% — now represents 1% of 85% = 0.01 x 0.85 = 0.85%.
So net-net what we have now is:
Founders: 9,250,000 shares have been diluted to 78.62% from 92.5.%
Options issued: 650,000 shares have been diluted to 5.53% from 6.5%
Options available: 100,000 shares have been diluted to 0.85% from 1%
Now we need to calculate how many preferred shares our SAFE investors get. We know that SAFE Investor A gets 5% and SAFE Investor B gets 10%. But how do we calculate how many preferred shares this grants them?
Because we know they have taken 15% of the company, and that their preferred shares are newly issued in addition to the 10,000,000 fully diluted shares already available, we need to calculate how many additional shares are to be added.
To this we take the 10,000,000 original shares and divide by 0.85 (the 85% balance after the SAFE Investors’ take of 15%, i.e., “the new 100%”) to determine the total amount of shares including the new preferred shares. We divide by 0.85 because we know that the current number — 10,000,000 — is 85% of the total; hence, to determine the total we divide by 0.85, which gives us 11,764,705 shares, i.e., an additional 1,764,705 preferred shares.
💡 If this division by 0.85 isn’t making sense, consider the inverse: suppose you knew we had 11,764,705 shares, of which, 85% was what remained after the investors took their 15%. What’s 85% of 11,764,705? It’s 11,764,706 x 0.85 = 10,000,000. So to go backwards, you simply divide by 0.85 instead of multiply by 0.85.
So now that we know there are 1,764,705 additional preferred shares, from here the math is simple to determine each investor’s take. We know that Investor A has 5% and Investor B has 10%, so:
SAFE Investor A: 11,764,705 x 0.05 = 588,235 shares
SAFE Investor B: 11,764,705 x 0.10 = 1,176,470 shares
In case you’re wondering why we’re calculating the investors’ shares as a percentage of the total 11,764,705 shares rather than a percentage of just the preferred shares, it’s because although they take only preferred shares (rather than common stock), their ownership is based on a percentage of the total number of all shares, and not just the preferred shares.
So in the end, we end up with a cap table as follows:
Founders: 78.62% (9,250,000 common shares)
Options issued: 5.53% (650,000 common shares)
Options available: 0.85% (100,000 common shares)
SAFE Investor A: 5% (588,235 preferred shares)
SAFE Investor B: 10% (1,176,470 preferred shares)
It’s worth noting that this entire exercise has assumed that the priced round (the Series A round) came in at a higher valuation than the valuation cap for the SAFE; remember, that was the whole point of a SAFE, right, that the investors were getting a better a deal (a lower company valuation) because they put in money at an earlier date, when the startup was only in its infancy, and in exchange for deferring their equity to a future date.
But suppose the Series A valuation was priced at a lower company valuation than the SAFE round. Well obviously in this case it would effectively defeat the entire purpose of the SAFE, right, because it wouldn’t be fair for the SAFE investors to get a worse deal, i.e., a higher valuation than the Series A investors. Remember, the SAFE Investors took the greater risk by investing early and deferring their equity until the Series A. In this case, the SAFE investors would just automatically default to the Series A valuation to ensure they’re not worse off. In this scenario the SAFE investors would have lost any company valuation benefit they would have expected to realize, but at least they aren’t harmed, i.e., they don’t lose anything; they simply don’t gain anything extra by virtue of the preferential company valuation.
(2) Option pool is created or increased if not yet there
So as discussed several times above, it’s time to finally enlarge the option pool for future hires. Again, 10-15% is typical, so let’s call it 10%. How does this math work out?
It’s complicated so we’re going to cut a lot of corners here, but essentially the steps are:
Sum up all shares but subtract out the 100,000 of currently available options at this point, i.e. 10,000,000 + 1,764,705 - 100,000 = 11,664,705
Recognize that this number represents 65% of the total company once you’ve subtracted out the other investors’ takes and the need for an additional 10% going to the option pool.
Now set up a simple equation: 10% / 65% = x / 11,664705 which gives x = 1,794,750
Subtract away the 100,000 options currently available: 1,794,750 - 100,000 = 1,694,750
So in general,
(X% / Y% = x / y)
Solve for x
Subtract away the currently available options (because we’re not starting from 0)
where
X% = the desired increase in the option pool
Y% = the total % of the company represented by all shares less the available options
x = the resulting number of shares
y = the sum total of all shares less the available options
(3) New Series A Investors invest
To figure out the final cap table and resultant dilution of the founders and prior SAFE investors’ stock, as well as the new Series A Investors’ share count, we need to figure out three different things: (1) the price per share; (2) the final capitalization of the company, i.e., the total number of shares; and (3) the number of shares to each investor.
The price per share
This calculation is straightforward. Simply take the Series A valuation of $15M and divide it by the total number of shares (determined previously to be 13.455M) and we get $15M / 13.455M = $1.114 per share
The final capitalization of the company, i.e., the total number of shares
Here we sum up the total of all types of shares (10M + 1.76M + 1.695M) which gives us 13.455M shares.
The number of shares to each investor
So now we know the price per share ($1.114) and the total number of all shares (the total fully diluted shares after the SAFE conversion and option pool increase, i.e., 13.455M).
First we figure out how many shares the $5M Series A investment buys at $1.114 per share: $5M/$1.114 = 4.48M shares.
Then we calculate the Lead Series A Investor’s take: $4M/$1.114 = 3.59M shares.
And finally, the other Series A Investors’ take: $1M/$1.114 = 0.897M shares.
And of course from these numbers we can work backwards to figure out the percentages of each category of shareholder and we end up with a final cap table that looks like this:
Founders: 9,250,000 common shares @ 51.54%
Options issued: 650,000 common shares @ 3.62%
Options available: 1,794,558 common shares @ 10%
SAFE Investor A: 588,235 preferred shares @ 3.28%
SAFE Investor B: 1,176,470 preferred shares @ 6.56%
Series A Lead Investor: 3,589,375 preferred shares @ 20%
Series A other investors: 897,344 @ 5.0%
Total shares issued: 11,694,558 common shares + 6,251,424 preferred shares = 17,945,982
And that’s SAFE dilution math!
Tips for Navigating SAFEs
Stick to One Instrument: It's advisable to stick to either SAFEs or convertible notes but not both, to avoid complications. Remember that SAFEs are not debt (like convertible notes).
Pre-Money vs. Post-Money SAFEs: It’s possible to combine the two, but this makes the conversion much more complicated, not least of which because pre-money SAFE dilution is already harder to calculate.
Don't Over-Optimize: Negotiating too hard on valuation caps often leads to minimal gains in ownership percentages, making the effort not worth the potential downside of complicating negotiations.
Conclusion: A Balanced Approach to Startup Financing
SAFEs offer a simplified, flexible option for early-stage startup financing. While they have numerous advantages, they are not devoid of complexities. Founders and investors should be well-versed in the intricacies of SAFEs to make informed decisions. This knowledge will not only streamline the investment process but also lay the groundwork for the startup's financial future. For more information, contact Marc Hoag Law.