SAFE is simple but there are critical details to understand to avoid mistakes with investors

Originally, the only way to invest in a startup was to buy equity — common or preferred shares.

But stock documents are complicated, and can take tens of thousands of dollars in lawyers’ fees to negotiate the terms and issue. That’s not the way a founder wants to spend their time and money getting started.

For a long time, convertible notes were used as a shortcut to invest in early-stage startups. A convertible note is a loan that includes an option to convert the investment to stock in the company. This made it feasible to put money into a startup as a loan until a “priced round” when stock was issued.

However, a convertible note is legally a loan, not equity, causing some complications. It has a maturity date by which it has to be converted to equity or repaid. (Yikes!) It includes interest payments on which investors have to pay income tax even thought they only receive additional stock. (Aargh!) Worst of all, loans are not eligible for the incredible tax benefits the US government offers for investing in startups. (WTF???)

And while the convertible note is far simpler than stock documents, there’s still lots of details that require lawyers. So the startup community was ready for something better. When Y Combinator introduced the SAFE in 2013, it quickly became popular with accelerators and startups. But angel investors hated it, and many even refused to use it.

Fortunately, in 2018, YC revised the SAFE to make it more suitable for angel investors. The new version, known as SAFE v1.1 or the “post-money SAFE” has become the most common financial instrument for early-stage investing.

What is the SAFE?

The SAFE (Simple Agreement for Future Equity) is a short, simple document to buy stock in a startup. Kind of. It’s more like a pre-paid reservation to buy stock once the company makes stock available. You hand over your investment now, and get stock sometime in the future.

The great thing about the SAFE is that other than the name of the investor, company, and date, the only thing to fill in is the amount of the investment and the valuation cap or discount. Then sign and wire the money.

That’s it. No changes. The only thing to negotiate is the valuation or discount. Don’t let the lawyers touch it.

SAFE Versions

The SAFE documents are available at: https://www.ycombinator.com/documents

YC created 3 versions for US corporations:

  • Valuation Cap: specify the post-money valuation cap of the investment. This is considered the standard version.
  • Discount: specify a discount from the valuation in the priced round.
  • Most Favorite Nation (MFN): get the best terms for valuation cap or discount negotiated by any other investor.

There was previously a version that included both a valuation cap and discount. This is my preferred version and the one I’ve seen most often.

However, the cap+discount version has recently disappeared from the YC page. There was no explanation for removing it, and is still referenced in the SAFE User Guide. I’ll continue using this version until I hear some reason not to.

YC also created similar templates for startups based in Canada, Singapore, and Caymans.

Lastly, YC has a separate pro rata side letter that guarantees SAFE holders the right to invest in the priced round. Some investors will ask for this while others may not care.

Valuation Cap

The only negotiable term in the standard SAFE is the valuation cap. This defines the price to be paid for the shares when they are issued.

Rather than a specific valuation, the valuation cap is a maximum. The investor pays the smaller of the share price in the priced round or the valuation cap.

For example, if the SAFE valuation cap is $10M, and the priced round comes in at $15M, the SAFE investor acquires the shares based on a post-money valuation of $10M. If the priced round valuation is only $5M, the SAFE investor buys the shares at the lower price.

The current SAFE v1.1 uses a post-money valuation cap. The original 1.0 SAFE used a pre-money valuation cap. While the pre-money valuation cap was fine for accelerators, for complex reasons explained in this article, it was a disaster for angel investors, so please stick with the current post-money version if you want angel investors.

Discount

In some situations, rather than specifying a valuation cap, it makes more sense to specify a discount from the price negotiated in the equity round.

For example, if the startup expects to close a priced Series A round soon, but needs a small bridge to tide it over until the negotiations are complete, it might make sense to set a 20% discount from the Series A price rather than a specific valuation.

Some startups offer a 20% discount with no idea when the priced round will occur. That may be 2–3 years from now after the company has reached milestones that raises its valuation by 10x. A 20% discount off a $40M valuation for a startup that’s worth $4M now is hardly a good investment, and not one I’d have interest in investing in. So stick with a valuation cap except specific situations.

Most Favorite Nation (MFN)

A individual investor, especially during a friends and family round, may have no idea what a fair valuation is, and at that stage, the startup may not know either. In that case, the best solution is an MFN SAFE. This gives the investor the best terms any other SAFE investor negotiates.

Main Features of the SAFE

Here are the main features to understand about the SAFE.

Future Conversion to Equity

The SAFE itself is not a stock document. When you make an investment using a SAFE, investors are issued no stock in the company, only a promise that they will be issued stock when the company has its next equity financing.

In other words, when the company finally does a larger round that involves the issuing of actual stock, the SAFE investment will convert to stock with the same conditions. This equity financing is usually called a “priced round” and for a startup, is typically Series A. For the earliest startups, that can be years away.

No Maturity Date

Unlike a convertible note, the SAFE has no maturity date. For startups this is a critical reason to prefer a SAFE over a convertible note.

Convertible notes typically have a 12–24 month maturity by which time the startup has to complete a priced round. This maturity date creates an artificial deadline investors can use to push for concessions, or at least in theory, can demand repayment, pushing the company into bankruptcy.

1x Liquidation Preference

If the company is acquired before there’s a priced round, the investor is paid the larger of (1) the amount they’d get if the investment is converted to equity, and (2) their original investment back.

For example, if I invest $1M at a valuation cap of $10M and the company is sold for $20M, I get $2M. If the company is sold for only $5M, I get my $1M back. You can read a full discussion of liquidation preferences here.

However, before I get any return, all debt, including credit cards, salaries, and convertible notes, has to be repaid first. If the company is sold in a fire sale for $1M and there is $500K in bills and another $500K in convertible notes, there’s nothing left for me. This is one reason some angel investors prefer convertible notes over SAFEs.

No Investor Rights

Until the SAFE is converted to equity, I get none of the protections that come with being an actual shareholder.

  • No shareholder voting
  • No representation on the board of directors
  • No informational rights on the company’s financial condition

In fact, the agreement provides almost no legal rights other than converting my investment to real stock someday.

No Investment Round Structure

Issuance of preferred equity requires a formal investment round. The raise has a maximum amount, and also a minimum. Investment money is held in escrow until all the money is collected, at which time the round is closed, documents signed, and the money distributed to the company.

Sophisticated angels and VC firms may require a minimum and maximum raise, but the SAFE can also be flexible. Especially at the earliest stages, it’s not unusual to collect $10K from one investor today on a SAFE with a MFN, $25K from another next month with a SAFE with a discount, and receive a $100K investment from an accelerator a month after that with a valuation cap.

There is no requirement that all investors receive the same terms. However, at some point, everyone is likely to see the cap table and it’s not a good idea to make investors feel they were taken advantage of with unfair terms. So it’s best to set a valuation cap to use consistently, raising it when the company hits major milestones.

It’s an Equity Investment. Maybe.

The SAFE declares that is it intended to be characterized as the purchase of equity, thereby making the investor eligible for valuable tax benefits (but only if the startup is a US-based S-corporation.)

However, just because the document declares itself to be equity for tax purposes doesn’t mean the IRS has to agree. Their opinion is the only one that matters and they have yet to say.

Given that investment has to be considered either debt or equity and a SAFE is clearly not debt, there’s a good argument that the investment is eligible for the relevant tax breaks, making it better for investors than a convertible note.

The SAFE User Guide

YC has put together a helpful document to explain details like pre-money vs post-money valuations, and how to factor employee options into the calculation. If you’d like to know more, the SAFE User Guide is your next stop.

Send me your SAFE agreements

I’m a big fan of the post-money SAFE for early-stage investments. They’re simple and fast and require no negotiation. But make sure you’re using the post-money SAFE, because the original pre-money SAFE is a non-starter.

Disclaimer: I hate disclaimers. But I need to emphasize I’m not a lawyer and this is not legal advice. I only made it through 1 year of law school before realizing I didn’t want to spend my career writing disclaimers for other people. I’m not an accountant, either, and can’t even do my taxes without the help of a CPA. I have no particular expertise on the SAFE document except having signed a bunch of them as a founder and investor. So don’t trust anything I say.

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