In 2013, Y-Combinator introduced an investment document for startup companies called the Simple Agreement for Future Equity (“SAFE”). As a practical explanation, a SAFE is a contract between a company and an investor that will grant the investor equity in the future, upon the occurrence of certain triggering events.
The SAFE was created as a form of a "bridge" investment vehicle for startup companies — a document that is intended to be quick, simple, cost-effective and to provide companies with capital to push toward an equity round of financing. Over the last five years, the SAFE has evolved to be more widespread and is not solely used as a bridge round of financing. The amount of money invested on SAFEs has increased to the point that it often more closely resembles the size of an equity round of financing. As a result, in September of 2018, Y-Combinator modified the form SAFE in order to accommodate the evolving use of the document.
While the new SAFE has a plethora of modifications to the previous SAFE document, this article touches on the most consequential of changes — the use of a valuation cap. The previous version of the SAFE incorporated a valuation cap that was presented as a pre-money valuation of the company. In other words, the valuation cap was intended to show the value of the company prior to a SAFE converting to equity.
By way of an example, under the previous document, if the valuation cap was $1 million, and the SAFE investors invested $200,000, the post-money valuation would be $1.2 million following the conversion of the SAFE. As such, using simple math, this SAFE would effectively purchase 16.67% of the company ($200,000.00 divided by $1.2 million). Note that these conversion percentages are typically a best guess and do not account for other variables that come into play (option pool increases, previous investments using other mechanisms, subsequent SAFEs, etc.).
While this appears straightforward if you only had one investor or if all of the investors came in at the same time, it often did not offer investors a clear idea of what their equity percentage would look like if later SAFEs were sold at the same or different valuation caps. Using the same math as above (and not accounting for the other variables touched on above), if an additional $300,000 of SAFEs were issued, the post-money valuation would be $1.5 million. The initial $200,000 would now be worth 13.33% ($200,000 divided by $1.5 million). In essence, future SAFE purchasers were diluting previous SAFE investors and ultimately defeating one of the core tenants of the SAFE: transparency. The previous SAFE made it somewhat difficult for investors to ascertain what they were purchasing due to the increase in amounts, rounds and terms of SAFE investments.
To combat this issue, the new SAFE includes modifications that are both investor- and company-friendly. In this new version of the SAFE, the valuation cap is presented as a post-money valuation. As such, the investors have a much better idea of the outcome of their investment (assuming conversion at the valuation cap, and not the discount rate). By presenting the valuation cap as post-money valuation, the investors are less likely to be subject to unanticipated dilution. As an example, using a post-money valuation cap, if the valuation cap was $1 million and an investment of $200,000 was made, the investors now know that this would be equal to 20% ($200,000 divided by $1 million). If a future investor came in for $300,000, like the original example, it would not dilute the first investor.
Although these updates give the investor more clarity, it is still not perfect. These percentages are calculated immediately prior to the equity financing. These investors may still be diluted by the round of equity financing that triggers their conversion, however, not by each subsequent SAFE investment, which was the case in the previous version of the SAFE.
Another important modification is the removal of the pro-rata rights provision. The previous form version of the SAFE granted pro-rata rights to all SAFE holders, which granted investors the right to participate in the equity round following the round in which the SAFE converted (one round removed), in order to maintain ownership percentage. As the size of SAFE rounds increased, the pro-rata rights had potential burdensome impacts on future rounds. The new SAFE has introduced an optional side letter, which, if implemented, grants investors these pro-rata rights in the round they convert to equity. As such, the removal and optionality provided to the company allows the company to decide if it is something they would like to offer their investors.
The new SAFE has improved on the first iteration in providing greater transparency to both investors and founders. These improvements provide more clarity in regard to the SAFE’s impact on the cap table of the company.
This post is not intended to provide legal, financial or tax advice, and if you are considering an issue regarding the topics discussed in this post, you should seek legal, tax, financial or other business counsel to help you make the right decision.
We used a simple mathematical approach for ease of understanding and illustrative purposes only. Please be advised that other variables will likely be considered that would change the numbers and formulas presented in this article.