SAFE Financing – a Deep Dive on the Evolution of the SAFE

Emerging Companies & Venture Capital

As we've noted in a previous article, the Y Combinator-hosted SAFE (Simple Agreement for Future Equity) has become the investment contract of choice for startup companies that have already attracted investors. However, the SAFE still competes with other forms of investment contracts used by startups and investors so it is worthwhile to compare their advantages and disadvantages. It is mostly the perceived difficulties and disadvantages of the other alternatives that the SAFE was intended to solve.

Long-time viewers of Shark Tank, and other novice entrepreneurs might wonder, "How hard can it be to close an investment? The startup and the investor can just agree on what percentage ownership the investor will get for a set amount of investment." Now that we think about it, we might suggest that to Y Combinator. It could be version 2.0 of their SAFE, taking the 7-page document down to a couple of sentences! While Y Combinator is thinking about that, we'll look back at the main forms of startup financing documents being used before (and after) the introduction of the SAFE in 2013.

Early Stages of Early-Stage Financings

Back in 2013, the gold standard for experienced investors to invest in startups was a "priced round," meaning that the investors and the startup founders would first agree upon (1) what the startup was worth, in dollar terms (the "pre-money valuation") and (2) how much money the investors would invest. From those dollar amounts, simple math dictated (3) the "post-money valuation" - what the company would be worth after the investment (i.e., 1 + 2), and (4) what the investor's ownership percentage would be after the investment (i.e., 2 / 3). After negotiation of those points, the investors typically also negotiated for a number of other contractual benefits. The documents for those priced rounds expanded in complexity over the years and were standardized into a set of five main documents now hosted on the National Venture Capital Association's document repository, consisting of over 200 pages just for the five main documents (not kidding!). And that doesn't even include the "ancillary" and optional documents the NVCA hosts for a priced round.

That kind of deal is too complicated for most investors and startup founders to handle on their own, so they would hire super-smart and expensivefairly priced lawyers to help negotiate and document the deal. But for a lot of early-stage financings with smaller investment amounts, everyone agreed there was a need to simplify things and to reduce costs. The difficulty of agreeing upon a pre-money valuation (the core element of a priced round) for a startup, which might not even have a product in development yet, created another incentive for alternatives that did not require consensus on the fair market value of a very early-stage company.

Before the SAFE, the simplest approach to early-stage investment was for the startup to borrow money from the investor using a convertible promissory note. With the convertible note, the parties mutually expected that a priced round would soon follow, so it would only be a short-term loan. The note would convert into equity at the time of the priced round with the benefit of a negotiated discount. Critically, there was no need to set a pre-money valuation. Even though the convertible note structure was dramatically simpler than a priced round, the parties still needed to negotiate a number of variables. The most important variable was the discount percentage - the percentage discount the investor would receive when converting the note, compared to the price to be paid by other investors in the priced round. As a loan agreement, the note would also include an interest rate and a maturity date. If a priced round hadn't closed before the convertible note matured, the startup would be legally obligated to repay the loan. Even though the convertible note was technically a loan to the startup, everyone knew that the company couldn't repay the loan if it never closed a priced round. That left an obvious question - what would happen if the startup could not close a priced round before the maturity date? There are no simple answers to that question, creating the need for a new negotiation between investors and the startup.

Those were the main problems Y Combinator tried to address in releasing the first SAFE in 2013. A priced round was too complicated and expensive for many first-stage financings. Convertible notes were less complicated and expensive, but they were derived from a loan structure that did not make much sense in practice because there was no way a startup would be able to repay the loan when the convertible notes became "due." The only hope for success was that the startup would close a priced round in the future, and the notes would benefit from their negotiated discount by converting to equity at time of the priced round. In that light, the main thing investors cared about was the conversion discount and all other terms were only secondary considerations. That conversion discount was defined in the terms of the convertible note as the discounted "conversion price."

Introduction of the SAFE

So Y Combinator launched the SAFE. The earliest versions of the SAFE were only 5 pages long and covered mainly (1) the amount of the investor's investment and (2) one or both of the following variables: (a) the discount the investor would get whenever the priced round closed, (b) a cap on the conversion price of the SAFE if the priced round exceeded a negotiated cap on the pre-money valuation. Investors who negotiated for a conversion price cap were trying to protect themselves against a "runaway valuation" - a situation where the startup might become so popular among later-stage investors that it could convince those later-stage investors to invest at a very high pre-money valuation that would have been unrealistic and inconceivable at the time of SAFE investment. With only a couple of variables to be negotiated, the SAFE was so popular that its use grew at an exponential rate.

That explosion in use of the SAFE led to some unexpected results. Originally, when using convertible promissory notes and then with the initial versions of the SAFE, investors expected that a priced round would be completed within 6-18 months. With convertible notes, that timing expectation was dictated by the maturity date. In contrast, the SAFE's lack of a maturity date, combined with its low cost and ease of use, led startups to fund their operations using multiple rounds of SAFE financings over several years, instead of closing a priced round in the near term. Some of those multi-year, multiple-round SAFE investments left investors in limbo, with no equity and no ability to force resolution because of the lack of a maturity date.

The use of SAFEs for multiple rounds of financing led to another problem that was compounded by Y Combinator's design of the SAFE so that a startup could negotiate unique terms with each investor - so called "high resolution financing." This led to startups that, as they grew and issued more SAFEs, might have SAFEs with multiple different discount rates and conversion price caps, reflecting the startup's progress and changing financing environments over time. Investors found it difficult to understand what ownership interest they would have in a startup once it completed a priced round, because of the way inconsistent provisions of multiple SAFEs interacted.

"Post-Money" SAFES

To address those surprises and other changing market expectations, Y Combinator has continued to evolve the standard SAFE forms. The most significant change was the introduction in 2018 of the "post-money" valuation cap form. The revised form of SAFE sets the maximum valuation applicable to the conversion of the SAFE at the time of the priced round of financing, regardless of the pre-money valuation used in the priced round. If the price per share used in the priced round is lower, then the SAFE converts at the same price as the priced round but, if the post-money conversion price cap is lower, the SAFE converts at that lower price. Critically, the post-money conversion price cap formula treats all existing SAFEs and convertible notes as part of the negotiated valuation cap. In practice, this feature enables the investor to know in advance the minimum percentage ownership they will have just before the closing of the priced round. For example, if an investor made a $250,000 investment using a SAFE with a $5,000,000 post-money valuation cap, the investor would know that they will own at least 5% ($250,000 / $5,000,000) of the startup just before the startup's priced round of equity financing, regardless of the pre-money valuation of the priced round and regardless of how many other SAFEs the startup sells before the priced round. The clarity that the post-money valuation cap SAFE offers investors led to the rapid adoption of the new form by most SAFE investors.

Current Practice

At this point, the primary SAFE forms being used by startups and investors are the post-money valuation cap form (labeled "Valuation Cap, no Discount" on the Y Combinator SAFE document repository) and the standard conversion discount form (labeled "Discount, no Valuation Cap" on the Y Combinator SAFE document repository). The post-money valuation cap form is most useful when the investor's priority is having certainty regarding a specific (minimum) ownership percentage of the startup at the time just before its first priced round. However, that certainty comes with the risk that the investor might not actually get any economic benefit from investing in the SAFE, if the share price used for the priced round is less than the conversion price resulting from the conversion price cap. In contrast, the conversion discount form is the version that most closely matches the original purpose of the SAFE, when the investor simply wants to be guaranteed a specific discount on the negotiated price used in the priced round.

Chris has spent most of his career as a strategic legal advisor to company founders, board members, executives, and investors, primarily for companies in the information technology and life sciences industries. His deep experience with companies in those industries helps him bring a practical business perspective to his legal work. Chris often serves as outside general counsel for these companies, and his practice includes a high volume of seed and venture capital financings, private placements, and mergers & acquisitions for his clients. You can email him at [email protected].

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.

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