SAFEs have some similarities to convertible notes, but are very different. We discussed convertible notes in the post “Convertible Notes: An Overview.” I recommend reading that post before continuing reading this post.
Let’s dive in.
A SAFE is a contract between a startup company and an investor where the investor provides the company with money which will convert into the securities issued in a future financing, usually preferred stock.
A SAFE is not stock – it’s a financing contract that will convert into stock of a future equity financing round. A SAFE is also not debt, so it is very different than convertible debt. To me, a SAFE is bit like a warrant where the exercise is contingent upon certain events happening. We discussed warrants in the post “Private Company Warrants: An Overview.”
Y Combinator has made SAFE forms and a user guide available on their website: https://www.ycombinator.com/documents/. Note that the SAFE forms were updated in 2018, so make sure you use the latest (post-money) versions of the forms.
The SAFE contract is a relatively short 5 to7-page contract between the company and the investors in the SAFEs. The contract contains the key terms of the SAFE contract. In some cases, a side agreement (called a “side letter”) will be entered into between the company and a SAFE holder which provide the SAFE holder with additional rights that aren’t in the basic SAFE contract. We’ll discuss side letters later in this post.
SAFE Purchase Amount
The “Purchase Amount” of a SAFE is the amount the investor invests in the SAFE. So, if an investor invests $100,000 in the SAFE, the Purchase Amount is $100,000. This term “Purchase Amount” is important as it appears in many places in the SAFE.
SAFEs are not debt instruments, so there is no interest that accrues on the SAFE amount. Convertible notes, by comparison, do accrue interest.
No Interim Payments
There are no scheduled repayments of the amount invested in the SAFE. This is the same as a convertible note.
No Maturity Date
Convertible notes have a maturity date, so that if the expected financing doesn’t occur by that date, the convertible notes become due and payable. SAFEs have no maturity date or expiration date. What that means is that if the Equity Financing doesn’t occur, the SAFE could sit out there indefinitely. This is a problem for investors because the SAFEs aren’t stock and they aren’t debt – they’re a “tweener.” Because SAFEs aren’t stock, it means the holders of SAFEs have no voting rights or other stockholder rights (such as inspection rights). Because SAFEs are not debt, the SAFE holders aren’t creditors. So SAFE holders aren’t creditors and they aren’t stockholders. This means if a company fails, SAFE holders could be left out completely and lose all their money. Because of this, some SAFE investors will require a side letter (discussed below) that address these issues.
Conversion on Equity Financing
The SAFE will automatically convert into the stock issued in an “Equity Financing” which is a financing where the company raises capital at a valuation that is negotiated (fixed) between the company and the lead investor in that financing (these fixed valuation financings are often called “priced rounds”).
Example. Lattamattic is raising a SAFE round. The seed-stage venture capital firm Poppy Seed Ventures invests $100,000 in Lattamattic’s SAFE. Lattamattic raises a total of $500,000 in SAFEs. Six months later, Lattamattic raises a $2 million Series A preferred stock financing at a $10 million valuation negotiated between the company and the lead investor. All of the outstanding SAFEs convert into this Series A financing.
Note that there’s no minimum amount that needs to be raised in the Equity Financing, so the SAFEs could convert in a small priced round. Also, as stated above but it bears repeating, if the company never raises an equity round, the SAFE could theoretically sit out there forever.
Similar to convertible notes, SAFEs usually have discounts or valuation caps as incentives for investors to invest in the SAFE. A discount means that the SAFE will convert into the Equity Financing at a discount to the price paid by the investors in the Equity Financing. Most SAFE discounts range from 5% to 25%.
Example. Angel investor Betty invests $100,000 in a SAFE issued by Lattamattic, which SAFE has a 10% discount. Lattamattic later has its Series A financing at a price of $1.00 per share. Betty’s SAFE will convert into Series A stock at a price of $0.90 per share (reflecting the 10% discount), and so Betty will receive 111,111 shares of Series A preferred stock.
Again, similar to convertible notes, SAFEs may have a valuation cap. A valuation cap is an amount agreed by the SAFE holder and the company so that if the Equity Financing is raised at a valuation greater than the cap, the SAFE will convert at the lower cap amount, meaning that the SAFE holder will get more shares in the Equity Financing. A valuation cap is not a formal valuation – it’s simply a mechanism to provide a benefit to the investor. The formal valuation occurs when the company raises a formal preferred stock financing round and negotiates a fixed valuation with the lead investor. In this way, SAFEs allow the difficult valuation conversation to be kicked down the road.
Example. Angel investor Zoe invests $100,000 in a SAFE issued by Lattamattic, which has a $10 million valuation cap. Lattamattic later raises a Series A financing round at a $20 million valuation, which translates to $2.00 per share. Because Zoe’s SAFE has a $10 million cap, this means that Zoe’s SAFE will convert at $1.00 per share for 100,000 shares. New investors to the Series A financing investing $100,000 will receive 50,000 shares, so the valuation cap in Zoe’s SAFE provides great benefit to Zoe.
SAFES with Both a Discount and a Cap
SAFEs can have both a discount and a cap. In these situations, the SAFE holder will choose to have the cap or discount apply based on which will provide the investor with the most benefit.
Example. Angel investor Bertrand invests $100,000 in a SAFE issued by Lattamattic that has a 20% discount and a $10 million valuation cap. Lattamattic later raises a Series A financing at a $12 million valuation. The 20% discount means that Bertrand can convert at a valuation of $9.6 million ($12M * (1-20%)), so the note will convert at a valuation of $9.6 million. If however, the Series A was valued at $15 million, then the 20% discount would mean that the SAFE would convert at a $12 million valuation, so in this case the SAFE would convert at the lower $10 million valuation cap.
SAFE Preferred Stock
When the SAFE is converted into the shares issued in the Equity Financing, the stock received is actually slightly different than the stock received by the investors in the Equity Financing. The stock received by the SAFE holders is called “SAFE Preferred Stock”, and it is identical to the stock issued in the Equity Financing, except for 3 things: liquidation preference; initial conversion price and dividends. For a discussion of liquidation preferences, see the post “Preferred Stock Financings: Understanding the Liquidation Preference.” For more on conversion, see the post “Convertible Preferred Stock: Understanding the Conversion Feature.” For more on dividends, see the post “Preferred Stock Financings: Understanding Dividends.”
The reason why SAFE Preferred Stock is issued is because of an anomaly. If holders of SAFEs get a discount to the price paid by the new investors, but receive the same stock, the holders of the SAFEs get a double benefit. Not only do they get a discount to the purchase price paid by the new investors, but they get the exact same stock as the new investors, which has a higher purchase price, liquidation preference and dividend payment.
Huh, you say?
Let’s go through an extended example to make the point.
Example. Lattamattic raises $100,000 from angel investors by issuing them SAFEs with a 20% discount. Lattamattic later raises a Series A preferred stock round at a price per share of $1.00 per share. This Series A preferred stock has a 1.0x liquidation preference ($1.00 per share) and is paid 5% dividends ($0.05 per share per year). The SAFEs held by the angel investors convert into Series A stock at a 20% discount, or $0.80 per share. If the SAFEs convert into the Series A stock, then they pay 80 cents for a share of stock that has a price of $1.00 but more importantly has a $1.00 liquidation preference and receives annual dividends of $0.05. Let’s focus on the dividends. If the SAFEs convert into the same Series A stock as the investors paying $1.00, they will get the same annual dividend of $0.05 per share as the $1.00 investors, but that means the SAFE investors are actually getting a dividend rate higher than 5%. They are actually getting a dividend rate of 6.25% ($0.05 per share dividend / $0.80 price per share). Now let’s look at liquidation. If the SAFE investors get the same Series A stock as the $1.00 investors, then they get a $1.00 liquidation preference, when they should only get an $0.80 per share liquidation preference. If the SAFE investors get a $1.00 liquidation preference, it means that their preference is 1.25x ($1.00 liquidation preference / $0.80 conversion price. This means the SAFE investors not only get a discount to the Series A stock price when the SAFE converts, but they also get more in dividends (on a percentage basis) and more in liquidation preference. This is called “double dipping.”
The Series A investors don’t want the SAFE investors to get the double dip, and so what happens is that a “phantom Series A stock” is created. This phantom Series A Stock will be called Series A-1 preferred stock, and will have all of the same rights, privileges and preferences as the Series A Stock, except that the price, liquidation preference, conversion ratio and dividends will be based on the discounted valuation from the SAFE.
Complicated? Yes, to the extent that only a lawyer could love. But it can get worse.
Complications from Multiple Discounts and Caps
If a company issues SAFEs with different valuations and caps, it can create a mess when the SAFEs convert. This is because each SAFE with different purchase prices will need its own phantom series of preferred stock. So, for example, if a company issues SAFEs at a 20% discount and later issues more SAFES at a 30% discount, then when the company raises a Series A preferred stock round at a $1.00 per share, this means that some SAFEs convert at $0.80 per share and some convert at $0.70 per share. To prevent the double dipping described above, there will have to be three series of Series A preferred stock: Series A with a $1.00 price per share; Series A-1 with a $0.80 price per share; and Series A-2 with a $0.70 price per share.
Makes for an ugly cap table.
Speaking of cap tables, where do SAFEs appear on a cap table? Because SAFEs aren’t debt and also aren’t equity, SAFEs often don’t appear directly on a cap table. Sometimes there are line items in the cap table for the SAFEs showing the amount invested but no equity ownership amount. Sometimes there’s a footnote and a separate tab in the cap table spreadsheet listing all of the SAFEs issued, the amounts, the discounts and caps, etc. When the Equity Financing occurs, the SAFEs are converted and the equity now owned by the former SAFE holders appears in the cap table.
If there’s a valuation cap, sometimes I have seen a SAFE listed on the cap table assuming conversion at the valuation cap. The only issue with this is that the preferred stock round may be issued below the cap, and so care must be taken when listing SAFEs directly on the cap table.
Sale of the Company
If the company is sold prior to an Equity Financing, the investor will be paid out. The amount depends on whether the SAFE has a valuation cap or a discount.
If the SAFE has a valuation cap, then in a sale the holder of the SAFE receives the greater of (1) the Purchase Price (the amount invested in the SAFE), or (2) an amount equal to the Purchase Amount times the company valuation in the sale divided by the valuation cap. For example, assume you invest $100,000 in a SAFE with a $10 million valuation cap, and before the company holds an Equity Financing, the company is sold for $20 million. You would receive the greater of (1) $100,000 or (2) $100,000 * $20,000,000 / $10,000,000 = $200,000.
If the SAFE only has a discount, then in a sale the holder of the SAFE will receive the greater of (1) the Purchase Price, or (2) the Purchase Price / (1 – Discount). For example, assume you invest $100,000 in a SAFE with a 20% discount, and the company is sold for $20 million before it holds an Equity Financing. You would receive the greater of (1) $100,000, or (2) $100,000 / (1-20%) = $125,000.
If the SAFE has both a valuation cap and a discount, the holder of the SAFE receives the greatest amount possible under the valuation cap and the discount. Using the examples above, if your SAFE had both the $10 million valuation cap and a 20% discount, then you would receive the greatest amount available, which is $200,000.
Initial Public Offering
If the company holds its initial public offering (“IPO”) prior to an Equity Financing, then the IPO is treated the same as a sale of the company. But it would be extremely rare for an early-stage company with a SAFE financing round outstanding to go public. I believe this provision exists “just in case.”
Side Letters; Most Favored Nation Rights
A side letter is a side agreement between the company and the investor made at the time the investor invests in the SAFE. The side letter can add provisions to the SAFE, or can change (amend) provisions in the SAFE. A common side letter provides the investor with “Most Favored Nation” or “MFN” rights. Most Favored Nation rights basically say that if the company gives rights to another SAFE investor that are better than the rights granted to a SAFE investor, then the SAFE investor can elect to have those better rights incorporated into the SAFE investor’s SAFE. Side letters can also contain additional provisions that can better protect investors. Consult your financial or legal advisor before you invest in a SAFE.
Why SAFEs are Popular With Entrepreneurs
- Minimal Negotiations. Because most of the terms of a SAFE are standardized, there are only a few things to negotiate with an investor: the Purchase Amount and the valuation cap and/or Discount. Note however, that if an investor wants additional rights, such as information rights, inspection rights, etc., then a side letter must be negotiated and things can get more complicated.
- Individual Contracts. Because SAFEs are contracts negotiated directly between a company and each investor, the company can negotiate each SAFE separately. This means the company can raise money a little bit at a time. Compare this to a priced round, where the company has to find a lead investor and line up all other investors, negotiate a valuation and the complex preferred stock financing documents, and have a single closing with lots of investors. SAFEs are much easier because they are contracts with each investor.
- Speed. Because of the reasons stated above, SAFE financings are very fast and efficient compared to priced rounds.
- Low Cost. Because SAFEs are standardized, it cuts down on the legal fees a company has to spend to issue a SAFE.
So from the company’s perspective, there’s lots to like about SAFEs.
- SAFEs are Not Notes. I hear people call SAFEs “SAFE Notes” and I think this is a troublesome characterization. SAFEs are not debt obligations of a company. If people start thinking that SAFEs are notes, they may think that SAFEs provide more protection to the investor than they actually do.
- SAFEs are Not Simple. Despite the name “Simple Agreement for Future Equity,” SAFEs are not simple. As you’ve read, there are a lot of provisions and nuances that go into SAFEs. Investors in SAFEs need to consult with their financial and/or legal advisors before investing in a SAFE.
- SAFEs are Not Safe. SAFEs are primarily used for startup companies. Startup companies have a notoriously high failure rate. The way SAFEs are structured, an investor in a SAFE may not get anything if the company fails. Also, because SAFEs are not equity, they don’t have voting rights or other protections that equity owners obtain. Finally, because SAFEs are not debt, they don’t have any of the benefits that a lender would have, such as priority payoff over stockholders in the event the company fails.
- Get Advice. Before you invest in a SAFE, make sure to obtain advice from your financial and/or legal advisors. These advisors can help investors structure a SAFE that provides better protection than a standard SAFE.
© Allen J. Latta. All rights reserved.