How do SAFEs Work?

As a new founder, you were inspired to help serve a sector and ultimately want to grow your startup with as little hiccups as possible. The rise and fall of a startup can be furious and understanding the various funding strategies that best fit your business is vital. Since Capbase is on a mission to help new founders understand more clearly the funding options available, we are going to explore SAFE notes.

In this article you'll find information on:

• What is a SAFE note and how it works
• Rolling Raise Strategy and how to implement it
• What is a valuation cap

A SAFE (Simple Agreement For Future Equity) is the second main type of funding used by early stage startups to secure early venture capital. Like its compatriot the convertible note, a SAFE allows startups to receive funding in exchange for equity later on—it converts to shares at a future date. Created specifically for startup funding, they almost always mature at the next round of financing (a seed round or Series A.)

Because convertible equities like the convertible note and SAFE do not explicitly set a price on the shares of the company, the fundraising round they support is usually referred to as an un-priced round.

SAFEs are a newer style of funding instrument that function like warrants, in essence allowing investors to buy a certain promised amount of equity at the next round. SAFEs were originally created by YCombinator in 2013 to replace convertible notes in un-priced rounds, but both instruments are now used simultaneously, as there are investors who prefer one financial instrument over the other for a variety of reasons discussed below.

Created by Y Combinator in 2013 as an alternative to Convertible Notes, sometimes called Y Combinator SAFE or YC SAFE), SAFE notes are now in their second generation and are still slightly less complex than convertible notes in their latest iteration.

SAFEs were intended to be used directly for un-priced funding rounds at startups, unlike convertible notes, which were adapted to the use.

Like convertible notes, SAFE notes terms include a valuation cap and discount rate which applies when they convert at the next equity round. However, they have no maturity date nor interest—features that are advantageous to founders, but not always appealing to investors.

Unlike convertible notes, SAFEs can convert at either pre-money or post-money valuation. To learn about the differences between pre-money and post-money, check out our article, How do SAFEs and Convertible Notes Convert During a Priced Round?

When it comes to early stage investing and deals made by angel investors, these investors earn most of their upside from taking risky bets and getting huge returns on equity. Setting an arbitrary clock on the next equity financing round is not in the company's best interest—or the investors best interest—since they only get desired investment returns from the exponential growth and continued success of your company.

An early stage investor that is hung up on terms like maturity date and interest could be viewed as a potential red flag. At this point, chances are that most savvy investors you interact with will be using SAFEs.

Because of the way SAFEs work, they make it especially easy to implement a rolling raise strategy in which you close different groups of new investors at different prices (e.g. 12 million, 13 million, 14 million) during a single “round”. Such a strategy can help companies take away the price-setting power from investors by setting the valuation cap on their own. It also creates FOMO in the investors considering a deal by arbitrarily setting close dates at which point the cap will rise. Here’s how this could look:

• You set a $1m target for fundraising at a valuation cap of $12m.
• You receive sizeable interest from investors after closing the $1m, and set your valuation cap to $15m with a target of another $500k.
• If you still have interest and want to raise more investment, you raise your cap to $18m and take in another $250k.

The rolling raise and similar strategies are often called “high resolution financing”, referring simply to the practice of creating different valuation caps or value for different SAFE holders.

Because they are simple to execute, SAFEs make a good choice for this strategy, as they don’t require much legal review and their terms are 100% standardized save for the additional clauses sometimes included in side letters attached to the investment. However, converting SAFEs to equity can get a bit messy, especially if there are SAFEs with MFN terms on the company’s books.

A simple SAFE may be issued without a valuation cap or clauses pertaining to dilution if it is accompanied with an MFN provision. In the case that a subsequent investor executes a SAFE to invest in the company with terms more favorable than the earlier investor, the MFN clause will allow an investor that executed a SAFE to receive the same terms.

In this way, adding an MFN clause can help alleviate worries by early startup investors that later investors will be receiving favorable rates.

While the valuation cap is not a “valuation” in the sense of a 409a valuation, it is one of your overall valuation methods it does set the tone for future financing—make sure you’re considerate when setting yours.

Like convertible notes, SAFEs can cause future dilution if their valuation cap is low or if many SAFE investors are added without due consideration.

Fortunately, Capbase has streamlined the SAFE and cap table processes so that it is simple to execute and you can see the future impact of your company’s early-stage financing. We also make it easy to understand if you would trigger substantial dilution by taking additional funding.

While SAFEs are fundamentally simpler than convertible notes because they do not have a maturity date or interest, they do have their own disadvantages and detractors. Because SAFEs have no maturity date and convert at the next priced round of funding, it is possible that SAFEs may never convert in the case that the company does not take a subsequent priced financing round. (Though this seldom occurs, it can.)

Consider the case of Toptal. The employee matching service did 200 million in revenue in the last year, but has no plans to pay out equity to investors or employees as all their equity agreements were based on raising another round of capital and their founder has declined to do so.

While the case of Toptal seems rather ...psychopathic, it is technically possible to misinterpret the terms of SAFEs this way, which is part of the reason some startup investors don’t like using them. However, these treatments are by far the exception and not the rule, and good faith agreements, pursued in good faith, comprise the majority of early-stage investment deals.

Capbase features help your startup stay organized with easy to use tools and features such as our Document Room and document templates. If you are interested in implementing a rolling raise strategy or creating SAFEs for investors, we can handle the paperwork for you. We simplify the process for SAFEs by providing pre-filled templates and visualizing future dilution on the company’s cap table. Sign up today and find out how Capbase is helping startups get funded..

• Early stage funding is typically done in unpriced rounds using either SAFEs or convertible notes.
• SAFEs were created by YCombinator in 2013 and have been subsequently revised.
• Current SAFEs are post-money warrants which grant investors a right to purchase future equity.
• SAFEs don’t have an interest rate and mature on the next priced round.
• Because of their standard language, SAFEs make an ideal vehicle for rolling raises and high resolution financing strategies.