The not so Simple Agreement for Future Equity (SAFE).
As they increase in popularity, startup founders must address the intricacies of raising capital through the unpopular Simple Agreement for Future Equity made famous in Silicon Valley.
Welcome, ambitious entrepreneurs and forward-thinking investors, to this week’s journal entry on one of the most transformative instruments in modern startup financing—the Simple Agreement for Future Equity (SAFE). As we embark on this journey, we'll delve into the intricacies of SAFEs, exploring their definition, applications, popularity, variations, real-world success stories, cautionary tales, and everything in between. Whether you're a startup seeking capital or an investor looking to support innovative ventures, this entry will equip you with the knowledge needed to harness the power of SAFEs effectively.
Likewise, I have added a few templates on different SAFEs for education purposes straight from their creators!
Demystifying the SAFE
The acronym SAFE stands for "Simple Agreement for Future Equity." Conceived by Y Combinator, a prominent startup accelerator, this groundbreaking concept was introduced to address the challenges that early-stage companies encounter when raising their initial rounds of funding. Aiming to streamline and simplify the investment process, the SAFE was a game-changer. Although the original SAFE has evolved since its inception in 2013, we'll focus our exploration on the Post-Money SAFE, the more recent iteration of this financing tool.
Diving into SAFE Mechanics
At its core, SAFE is a type of convertible financing. Distinct from traditional convertible notes, SAFEs diverge by not acting as debt instruments. Instead, they offer streamlined and concise terms, presenting a wealth of advantages for both founders and investors. Whether it is through a formal investment round, or through equity crowdfunding, SAFEs are versatile financial instruments.
One key distinguishing factor is the omission of maturity dates and interest rates, present in traditional convertible notes. Maturity dates stipulate when a convertible note must be repaid, often forcing founders into hasty equity rounds. SAFEs eliminate these pressures, granting founders greater flexibility and removing the urgency to expedite an equity round.
Investors opting for SAFE investments gain the right to convert their SAFE into equity during the next equity financing round or a liquidation event. This conversion process revolves around two vital components: the valuation cap and the discount rate.
The following video does a great job explaining SAFEs:
Valuation Cap and Discount Rate: Conversion Catalysts
The conversion terms of a SAFE pivot around either a valuation cap or a discount rate. A valuation cap defines the maximum price at which the SAFE can convert, offering investors the opportunity to secure more shares. Conversely, a discount rate provides investors with a reduced valuation for the priced round, translating to increased equity upon conversion.
There are four primary types of SAFEs (Click each for the respective template):
Both valuation cap and discount rate (investors' choice upon conversion)
"Most Favored Nation" clause (conversion based on the most favorable terms offered to investors in the next priced equity round - My favorite!)
For a better understanding on determining a valuation cap, be sure to check the journal entries on the Venture Capital Method and the Scorecard Method of valuations.
Mastering Liquidation Events and SAFE Impact
In the event of a liquidation, such as an acquisition, before a priced equity round occurs, SAFE holders face choices. They can either reclaim the initial SAFE investment (a "1x liquidation preference") or opt for converting their SAFE into common stock, selling those shares as part of the acquisition. Opting for conversion can be particularly advantageous if the acquisition price surpasses the valuation cap, maximizing investor returns. Be sure to assess your particular situation and conduct a proper scenario analysis. Likewise, it never hurts to seek an expert opinion.
Understanding both sides of the Coin
SAFEs deliver an array of advantages to both investors and founders, propelling their popularity within the startup landscape.
Investors relish:
Rapid Access to Early-Stage Investments: Streamlined processes enable swift investments in promising startups, requiring minimal negotiation and documentation.
Optimal Equity Terms: Upon valuation assignment during a priced equity round, SAFE holders experience more favorable conversion terms than later-stage investors.
Founders rejoice in:
Effortless Financing Access: SAFEs bypass the complexities of traditional equity financing, enabling founders to secure funding quickly.
Elevated Flexibility: Free from intricate shareholder voting rights and complex provisions, founders can concentrate on steering their company's growth with minimal investor friction.
However, it's important to acknowledge the potential downsides for both investors and founders.
Investors should bear in mind that:
Conversion Delays: The absence of maturity dates might lead to prolonged conversion waiting periods, as there's no urgent need for the company to rush into a priced equity round.
Suboptimal Terms: Depending on the chosen SAFE type, investors could face terms no better than those offered to later-stage investors upon conversion.
Forgone Interest: While short-term interest might not be concerning, extended SAFE holding periods can lead to missed interest earnings.
Founders must consider:
Potential Equity Dilution: SAFEs' conversion might result in more substantial equity dilution than expected, affecting founder control.
Investor Preferences: Some investors still favor convertible notes or traditional equity rounds, impacting funding prospects.
Valuation Decisions: Opting for a low valuation cap to expedite SAFE investments can have unintended implications during conversion.
Calculating Ownership Dilution from SAFEs
Determining potential dilution from SAFEs is crucial for both founders and investors. A simple method involves the formula:
Equity Dilution = SAFE Amount / Valuation Cap
For instance, raising $500,000 from a SAFE with a $5 million post-money valuation cap equates to a 10% equity stake. Doubling the investment to $1 million maintains the valuation cap but results in a 20% dilution. This calculation underscores the importance of understanding SAFEs' impact on ownership.
Furthermore, if you have not done so, be sure to check out the journal entry addressing the importance of dilution provisions on Employee Stock Option Pools (ESOPs). This is a must for every startup founder and prospective investor!
Navigating the SAFE vs. Convertible Notes Dilemma
The decision between SAFEs and traditional convertible notes is multifaceted. Founders must weigh factors such as capital urgency, investor preferences, and funding requirements. Investors should evaluate their willingness to wait for conversion, forego interest payments, and assess the value of the offered terms. Both instruments serve as bridges between early-stage funding rounds and subsequent equity rounds, but they possess unique characteristics that cater to varying founder and investor preferences.
Factors to Consider
Urgency of Capital: If your startup requires funding urgently to fuel growth or meet specific milestones, SAFEs might be the way to go. The absence of maturity dates in SAFEs eliminates the pressure to secure a priced equity round within a specific timeframe, giving founders more time to strategize.
Funding Amount: The size of the funding round can influence your decision. While SAFEs are efficient for smaller rounds, larger investments might be better suited for convertible notes, especially if lead investors prefer traditional instruments.
Conversion Timing: Consider when you anticipate the next priced equity round occurring. If you're confident about a near-future valuation event, convertible notes might offer more structured terms for conversion. However, if the timing is uncertain, SAFEs' flexibility could be advantageous.
Interest and Discount Rates: Convertible notes come with interest rates that accrue over time. If you're concerned about interest costs, SAFEs might be more appealing, as they lack interest-bearing obligations. Additionally, the discount rate in a SAFE can impact the conversion price, potentially benefiting investors.
Valuation Predictability: If you're confident in predicting your startup's valuation trajectory, convertible notes might align better with your plans. Their structure provides more clarity on the conversion terms, especially if you can anticipate the priced equity round valuation.
Literature and other Resources
The Holloway Guide to Raising Venture Capital: The Comprehensive Fundraising Handbook for Startup Founders by Andy Sparks. #ad
The Startup Company Bible For Entrepreneurs: The Complete Guide For Building Successful Companies And Raising Venture Capital by Stathis. #ad
The Art of Startup Fundraising: Pitching Investors, Negotiating the Deal, and Everything Else Entrepreneurs Need to Know by Alejandro Cremades. #ad
The Dr’s Order #6
As the spotlight shifts, it becomes clear that strategic alignment with a blend of flexibility and structured terms is key to steering startups toward enduring success. Don’t settle in your negotiation for simplicity regardless of the financial instrument your choose.
SAFEs represent an innovative solution, simplifying startup financing and expediting investments for both founders and investors. Their streamlined processes, potential for favorable terms, and reduced negotiation complexities have catapulted them to prominence. However, acknowledging potential drawbacks and thoroughly assessing the choice between SAFEs and traditional convertible notes based on unique circumstances is paramount. Don’t forget, there are other ways of raising capital that may prove simpler just like that shown on the journal entry on Startup Fundraising During Challenging Economic Conditions.
As we continue to navigate the uncertain waters of this startup apocalypse, be sure to equip yourself with these tiny bits of knowledge. If you felt this was useful, please share it with fellow entrepreneurs and investors to ensure we can all navigate this startup crisis.
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