Explaining SAFEs...and how they can be unSAFE

When you go to buy a new car, it would seem ridiculous to purchase anything without knowing all the terms involved - what’s the warranty? how high is my APR?

So why would you ignore the terms when investing in a startup?

There are several ways that startups structure their fundraising rounds, and one of the more common structures is caled a S.A.F.E.

Not understanding what a SAFE is could potentially cost you thousands of dollars, so today I’ll be breaking down this term for you.

Put your fork away because this one is going to be spoon-fed to you.

And for all the new subscribers who recently joined, I promise you that I will get back to more interesting topics shortly!

What is a Simple Agreement for Future Equity (SAFE)

In the 2000’s, startups had a problem.

It was difficult to obtain funding early on during the seed stage. Two hurdles were making it more difficult than Kevin Hart trying to get on roller coasters:

• Coming up with a valuation at such an early stage was difficult and guess-work at best

• Raising money on a priced round (where one gives away shares for $X) involves legal counsel and can be a timely process that takes months. Many young startups did not have the runway to wait for this process to play out

Enter Y Combinator, the famed startup accelerator. They noticed that a lot of their own startups were being hampered by this slow, ambigiuous process

Y Combinator decided to create a new way to raise money, through a format called a Simple Agreement for Future Equity (SAFE)

A SAFE is not equity in the company, but a promise that the investors are entitled to equity at some point in the future

Here’s How it Works

Let’s imagine that Startup X is using a SAFE to raise funds and I decide to invest $100,000. When Startup X raises a priced share round in the future, my $100,000 investment will convert into shares

If Startup X decides that each of its 1,000,000 shares are worth $1 in the priced round, I would receive a number of those shares. But it wouldn’t be fair for my shares to be converted for $1 each - then I would just be getting in at the same terms as the investors of this round!

I need to be rewarded for investing earlier in the company’s life cycle, so there are two types of terms that are added to a SAFE to help out investors:

1. Valuation Cap - a maximum valuation that the investor will convert shares at. In the above example, StartupX is worth $1,000,000 (1,000,000 shares x $1). A $100,000 investment at that time would grant you 10% of the company at $1 per share.

   1. If the valuation cap listed in the earlier SAFE is $500,000, my investment will be converted at that maximum valuation. ($500,000/1,000,000 shares = $0.50 per share.

   2. A $100,000 investment divided by $0.50 = 200,000 shares. In this scenario, I get a lot more shares and would own 20% of the company, as opposed to 10%

2. Discount Rate - A discount to the future share price. If Startup X lists their discount rate at 20%, I would convert equity at a 20% cheaper share price. So if the share price in the next round is $1, I would be able to buy shares at a 20% discount, or $0.80 per share.

   1. $100,000 divided by $0.80 would equal 125,000 shares, or 12.5% of the company

As you can see in both instances, the SAFE investor is rewarded with more lucrative terms during the subsequent priced round

Usually, a startup will choose to use a valuation cap OR a discount rate. In the event that both are used, the shares will usually convert at whatever terms are more favorable to the investor

How a SAFE can (sometimes) suck for an investor

SAFEs only convert your investment into equity when there is qualifying trigger event. In most instances, this is when there is a subsequent round with priced shares

But let’s say a founder has a cash-flowing business that doesn’t need additional investment - should they decide to never raise additional money, your SAFE investment will never convert into equity

Without equity, you don’t own a portion of the company.

I haven’t seen this happen in my experience, but it’s a risk that needs to be taken into consideration

The other pitfall of SAFEs is that if there is a valuation cap but no discount rate, you could end up investing at the same terms as later investors. This would only happen if the subsequent round is priced equal to or below the valuation cap specified

Have a question about SAFEs? Feel free to comment below and I’ll be sure to provide an answer!

We’re better when we’re together :)

As always, please conduct your own due diligence before investing, and consult your own legal counesel on advice concerning legal documents