Emerging Companies Practice Briefs
SAFE financings (it’s an acronym for “Simple Agreement for Future Equity”) were pioneered by the startup accelerator Y Combinator as a replacement for convertible notes. The idea was to create a simpler, more flexible alternative to convertible notes.
Like a convertible note, a SAFE allows an investor to manage upside risk by purchasing a future stake in a Company’s equity, and lets a founder raise funds without a formal valuation. The biggest difference between a SAFE and a convertible note is that a SAFE is not debt. An investor will get stock at a later date in exchange for the cash investment now. Since it’s not debt, there’s no maturity date and no interest rate. Whenever the company raises its next round of equity financing, the SAFE will convert into shares of the company’s stock.
There are two primary negotiated terms in a SAFE financing: the conversion discount and valuation cap. The conversion discount affects the price at which the SAFE converts. Let’s use an example: if an investor invested $100,000 in exchange for a SAFE with a 20% conversion discount, and the company then conducts a new financing at the price of $1.00 per share, then the SAFE investor will receive shares of stock at $0.80 per share.
The valuation cap sets a maximum conversion price for the SAFE investor. Using our previous example, let’s say the company in question had 5 million shares outstanding prior to the financing, and the new financing was being done at a $5 million valuation, giving us a per share price of $1.00 ($5 million valuation divided by 5 million shares). If the SAFE had a valuation cap of $1 million, the SAFE holder would receive shares valued at $0.20 per share ($1 million valuation divided by 5 million shares). If a SAFE has both a conversion discount and a valuation cap, the investor will convert at whichever share price is better.
Simple enough, right? Here’s where it gets a little tricky, though. Under the terms of the SAFE documents, the SAFE investment will convert into “Safe Preferred Stock” whereas the new non-SAFE investors will receive “Standard Preferred Stock.” The difference between the two is that the Safe Preferred Stock has a liquidation preference and conversion price equal to the original amount invested, rather than the price of shares issued to the new non-SAFE investors. So, in our previous example with a valuation cap, the Safe Preferred Stock would have a liquidation preference and conversion price of $0.20 rather than the $1.00 for the other investors.
Let’s finish with a quick look at some considerations for anyone thinking about this as a potential fundraising mechanism, from both the founder and investor perspective. For both founders and investors, a SAFE is often simpler and faster (and thus cheaper!) than a full-blown Series Seed or Series A equity financing. Companies benefit from the lack of a maturity date, since they don’t have to worry about hitting their milestones before a set time or negotiating an extension. But investors often want to have that set date as a way to motivate the company to grow quickly. Another pro for founders is that, like convertible notes, most SAFE financings don’t involve giving away control rights (like board seats), and, since the investor doesn’t hold shares until the SAFEs convert, they can’t vote on company matters right away. Although most founders like the idea of raising money without setting a valuation, doing so can lead to a lack of clarity on the company’s capitalization and founder dilution.
Last and keeping all that in mind, choosing a financing structure (like a lot of decisions startups and investors make) is a cultural decision as much as a legal and financial decision. For instance, SAFEs are an understood and common financing tool on the west coast, but are used less frequently on the east coast, so the geographic location of your company or investors may influence the success of a SAFE.
 A SAFE typically terminates only when the investor gets stock (in a conversion) or cash (in a change of control). It could, in theory, remain outstanding for an extended period of time.
 So, they will receive 125,000 shares ($100,000 investment at a per share price of $0.80 per share) instead of 100,000 shares ($100,000 investment at a per share price of $1.00 per share).
 A SAFE can have either a conversion discount or a valuation cap, or both a conversion discount and a valuation cap!
 The liquidation preference is the amount the preferred stock receives first before any assets are divvied up amongst the other stockholders in a liquidation event, unless they convert into common stock.
 The price at which the preferred stock can convert into common stock.
 But a good startup lawyer will make sure you have a fully-built pro forma capitalization table reflecting the notes and their discount and valuation cap so that you can model out different financing proposals and get comfortable with capitalization and dilution.
Christopher Poe is an attorney at Wyrick Robbins. His practice focuses on startups, helping businesses of all sizes and in all stages of development, from organization to exit. He assists startups with financings, including angel and venture fundings, and advises them on securities issues.
The purpose of this brief is to provide general information, and it is not intended to provide, and should not be relied upon as, legal advice.