An Essential Funding Tool for Early-Stage Startups
Introduction to SAFEs
Raising early-stage capital is one of the most crucial—and challenging—phases for any startup. Before having traction, user metrics, or even a fully launched product, many founders seek ways to fund their companies efficiently. SAFEs (Simple Agreements for Future Equity) have become a popular instrument for this purpose. Originally developed by Y Combinator in 2013, SAFEs allow startups to bring in early investments with minimal complexity and negotiation.
This guide distills key insights on SAFEs, based on insights from Kirsty Nathoo, CFO and Partner at Y Combinator, who has guided over 1,500 companies through early-stage funding and witnessed many common challenges firsthand. Understanding SAFEs can help founders avoid pitfalls, especially in how much ownership they’re giving up and in managing expectations around investor terms.
What Is a SAFE?
A SAFE is a convertible instrument allowing an investor to provide funding now, with the agreement that they’ll receive equity in the future. Unlike traditional equity investments or debt instruments, SAFEs are straightforward and don’t require the issuance of shares or repayment schedules, making them particularly suitable for early-stage startups.
A typical SAFE involves minimal negotiation—mainly the investment amount and the valuation cap. This simplicity makes SAFEs faster to implement than a priced equity round, which can involve negotiating a wide range of terms. In general, SAFEs convert into shares in the next priced funding round, effectively piggybacking on terms set with a lead investor in that round.
Key Features of SAFEs
- No Shares Issued Immediately
At the time a SAFE is signed, no shares are issued. Instead, shares are granted when a future equity funding round occurs. - Discounted Conversion
SAFEs often come with a discount (typically 10–30%) to reward investors for investing early. If a startup raises additional funding at a higher valuation, the SAFE’s discount lets early investors convert at a lower price. - Valuation Cap
The valuation cap sets the maximum valuation at which the SAFE converts. If the next funding round values the startup above this cap, the SAFE will convert at the cap, ensuring the investor receives more shares than they would at the market valuation. - No Interest or Maturity Date
Unlike convertible notes, SAFEs do not accrue interest or carry a maturity date. They simply convert when the next funding round occurs. - Pre-Money vs. Post-Money Basis
SAFEs can be based on either a pre-money or post-money valuation, which impacts how the investor’s equity is calculated. A pre-money SAFE calculates ownership based on the startup’s value before the SAFE investment, while a post-money SAFE includes the SAFE in the startup’s valuation, often reducing dilution for founders. - Additional Rights Are Optional
Some SAFEs include extra provisions, such as:- Most Favored Nation (MFN): Allows investors to adopt more favorable terms that future SAFE investors may receive.
- Participation Rights: Enables SAFE holders to participate in subsequent funding rounds.
- Information Rights: Requires the startup to share specific financial or operational data with investors.
Managing Your Cap Table and Ownership
A critical takeaway from Kirsty Nathoo’s experience is the importance of tracking ownership and dilution. Many founders assume that because SAFEs don’t immediately issue shares, they don’t need to monitor their cap table. However, it’s essential to understand how much of the company you’re giving up at each funding stage.
Maintaining an accurate cap table helps founders keep a close eye on their equity as the company grows. Tools like captable.io or Carta can streamline this process, but even a simple spreadsheet can work in the early stages.
Pro Tip: “It’s your responsibility as a founder to understand your cap table,” emphasizes Nathoo. Relying solely on legal teams can lead to unpleasant surprises down the line.
Example: How a SAFE Converts
Let’s take a look at an example:
- Investment: An investor contributes $100,000 via a SAFE with a 20% discount and a $3 million valuation cap.
- Next Funding Round: In the next round, the startup’s valuation is $6 million.
- Conversion: Instead of converting at the market rate, the SAFE holder converts at the valuation cap of $3 million, effectively securing a 50% discount on the startup’s latest valuation.
This setup rewards early investors, who took on greater risk, with a favorable equity stake.
Differences Between SAFEs and Convertible Notes
It’s essential to understand that SAFEs differ from convertible notes:
- No Debt Obligations: Unlike convertible notes, which often have a maturity date and accrue interest, SAFEs are not debt instruments. There’s no repayment obligation.
- No Maturity Date: Convertible notes typically convert or repay by a specified date, whereas SAFEs simply convert at the next equity round.
Tips for Founders Using SAFEs
- Standardize SAFE Terms
Using consistent terms for all SAFEs (other than the investment amount) simplifies cap table management. If an investor requires special terms (e.g., information rights), it’s often better to grant these in a side letter rather than modifying the SAFE itself. - Be Transparent with Investors
Being upfront about SAFE terms and side letters with other investors fosters transparency, ensuring that larger investors aren’t expected to receive the same treatment as smaller ones. - Understand Dilution and Fully Diluted Capitalization
Ensure you have a clear view of your capitalization on a fully diluted basis. Being clear on whether it’s calculated on a pre-money or post-money basis will help avoid future misunderstandings with investors and give you a solid grasp of how SAFEs impact ownership.
Summary: Key Takeaways on SAFEs
- Efficient and Simple: SAFEs provide a quick and straightforward way to raise funds without complex negotiations.
- Flexible Terms: SAFEs sidestep many valuation and investor term negotiations, streamlining the funding process.
- Know Your Ownership: Keep close track of your cap table and monitor how SAFEs affect your dilution.
- Different Convertible Options: While SAFEs are popular, other instruments include convertible notes and KISS agreements, each with unique terms.
- Consistency is Key: Aim to maintain consistent terms across all SAFEs to avoid administrative and conversion challenges in the future.
Closing Thoughts
SAFEs have revolutionized early-stage startup financing, offering founders a way to secure capital quickly and efficiently. However, it’s vital for founders to be well-versed in their terms and aware of the impact on ownership and control. By following the guidance here and maintaining a clear cap table, founders can set themselves up for a smoother funding journey and more transparent relationships with investors.
