PS#026: SAFEs
Alright, last week we covered convertible notes. This week we are going to discuss SAFEs.
SAFEs are a very common and popular financing structure for early-stage investors, especially at the pre-seed and seed stages.
Just like last week, we are going to answer…
What are they?
How do they work?
Why should you use them?
What are SAFEs?
SAFE stands for “Simple Agreement for Future Equity.”
The name says it all – they are very simple contracts with very few terms that promise future ownership for early investors.
The SAFE was introduced by Y Combinator in 2013 after seeing how difficult it was for pre-revenue companies to raise their first round of capital. Over the past decade, the use of the SAFE has expanded and it has become a common instrument within venture capital.
When a company is pre-revenue (and essentially just an idea or product), it is incredibly difficult to decide upon a true valuation. It’s much easier to predict where the valuation could or should be if the company is able to reach the next level (i.e., Seed or Series A).
This is the main purpose of SAFE – helping startups secure their first rounds of financing.
How do they work?
Compared to convertible notes, SAFEs are much simpler.
They focus on only a small subset of the terms included in a convertible note.
Unlike convertible notes, which behave as debt, SAFEs do not have…
Maturity dates – the date when the instrument must be repaid
Interest rates – the rate at which interest accrues on the invested capital
However, similar to convertible notes, SAFEs often do have…
Valuation Cap – the maximum amount at which a convertible note will convert
Discount Rate – discount rate to the valuation of the future priced round
The SAFE can offer the benefits of convertible equity, while alleviating the pressure of a debt instrument for very early companies. Of course, at the end of the day, this provides an avenue for temporarily aligning stakeholder incentives (as we discussed at the outset of this convertible instrument series).
Also important to note, SAFEs can use a combination of the two terms (similar to convertible notes). In some cases, you may have both, one of the two, or none of them (in which you would simply convert at the most favorable terms of the next financing round).
As you can see, these structures are much simpler for both founders and investors.
Now, there is one more element to understand, which is what happens in the case of a liquidation event (before any sort of priced round). If you’re a SAFE holder, you will have the option to receive back the original amount that you invested OR convert into common stock (based on the valuation cap) and partake in the upside of the exit.
Again, it keeps things pretty simple.
Why should you use SAFEs?
Just like convertible notes, the main reason for using a SAFE is that it is very difficult to determine and align on a valuation. And, as we discussed, this can be especially hard when a company is pre-revenue or pre-product. So, in this case, SAFEs create a mechanism for aligning the interests of early-stage founders and investors.
But, let’s look at some of the other reasons for using SAFEs…
Startups
Startups will use SAFEs for a few reasons…
Faster financing – due to its simplicity, SAFEs are exponentially faster (and easier to negotiate) than priced rounds or even convertible notes
Flexible financing – founders can raise on SAFEs over a rolling time period (similar to convertible notes)
Retain control – similar to convertible notes, SAFEs are not yet equity, so founders retain control of the direction of the company
Investors
On the other hand, investors will use SAFEs for…
Early access – early access to promising startups, ideas, technology, and/or founding teams
Speed – there is significantly less data to review for companies at this stage, so having a security can match that speed helps investors move quickly
Favorable conversion terms – similar to convertible notes as compensation for providing capital in advance of receiving equity, investors will often receive favorable conversion terms (vs. a future price round)
Especially at the very early stages, SAFEs make a ton of sense. Of course, founders and investors have to be careful as these instruments do not provide much structure (in the case of investors) and could lead to significant dilution (in the case of founders).
For the next issue, we’re going to walk through some of the typical (and not so typical) use cases for both SAFEs and convertible notes.
