SAFE is an acronym for Simple Agreement for Future Equity. It is an agreement between an investor and a company that allows investors to convert their investment into equity at a future price round or liquidation event.
A SAFE may contain specific terms, some of which include;
Valuation Cap: This specifies the maximum valuation at which the investment converts into equity shares or cash. This means that the investors will receive equity shares at the valuation cap price no matter the valuation at which the company sells. The higher the company’s valuation at the time of sale, the greater the investor’s return.
Qualifying Round: This is the priced round at which a SAFE will convert into equity. Usually, any priced round will be a qualifying round.
Price per Share: This is the cost per share when the investment converts into equity shares.
Discount: The discount provision gives investors equity shares at a reduced price relative to what others pay at IPO or for the company’s acquisition. It enables investors to buy shares at a discount on future financing.
Pro-rata Rights: These allow investors to invest extra funds to keep their ownership percentage during a future equity financing. This was common in Pre-money SAFEs. For the Post-money SAFEs, Y Combinator provided a pro-rata side letter that can be signed with specific investors in conjunction with the post-money SAFE.
Most-favored Nations Provision/ Non-discrimination Clauses: They require startups to give the same privileges to all investors, both previous and future. Therefore, if subsequent convertible securities are issued to future investors at a lower valuation cap or with more significant discounts, it will automatically apply to the SAFEs of earlier investors.
Types of Safe
A SAFE could be Pre-money or Post-money. The significant difference between the two is how the company’s capitalization is calculated. In a Pre-money SAFE, company capitalization excludes all securities converted into financing (pre-money valuation).
The investor doesn’t know yet what percentage of the company they own relative to the founders and other SAFE holders until after all SAFEs convert into shares during the subsequent funding round. Further, because the company’s capitalization excludes all convertible securities, a Pre-money SAFE does not dilute the founders as much as a Post-money SAFE.
Additionally, in calculating the conversion price, the total option pool is included even if the options have not been allocated, as well as the increase to the option pool occurring in connection with equity financing.
The company capitalization of a Post-money SAFE includes all the converting securities. As a result, Post-money SAFEs can dilute the founders to a greater extent than pre-money SAFEs. Also, a Post-money SAFE includes the entire option pool, but the increase to the option pool is generally excluded; this means that the Post-money SAFE ownership is post all other SAFEs but not post-Series A.
Post-money SAFEs are more common because they provide investors with greater clarity about how much of the company they will ultimately own. They also enable founders to understand how much dilution is caused by each SAFE they sell. In a Post-money SAFE, only the founders get diluted while the other SAFE holders do not get diluted.
Y Combinator has done away with its Pre-money SAFEs and, as such, is propagating the use of only Post-money SAFEs. A simple calculation to determine the ownership percentage of holders of a Post-money SAFE will look like the following;
If Skye Inc. gives an investor a $1 million SAFE with a $5 million Post-money Valuation Cap, the ownership percentage will be calculated as follows;
The Investment Amount ($1,000,000) is divided by the Post-Money Valuation Cap ($5,000,000) and multiplied by 100.
1,000,ooo/5,ooo,000 x 100/1 = 20.
It means the SAFE represents 20% of Skye Inc. And if the founders owned 100% of the company before issuing the SAFE, they now own 80%.
If the second SAFE of $500,000 is issued to another investor at a $10 million Post-money Valuation Cap, it will be calculated as follows;
The Investment Amount ($500,000) is divided by the Post-Money Valuation Cap ($10,000,000) and multiplied by 100.
500,000/10,000,000 x 100/1 = 5
The second SAFE represents 5% of Skye Inc., and the founders have been further diluted to 75%.
However, while the SAFEs do not dilute each other, they get diluted by Series A and any option pool increase in connection with such equity funding.