How do SAFEs work and convert at Series A?

The excitement of starting a company usually comes with the realization that you need to raise money. When raising startup funding, founders have many options, one of which is the use of Simple Agreements for Future Equity (SAFEs), a relatively flexible alternative to traditional equity financing

What is a Simple Agreement for Future Equity (SAFE)?

Years ago, the startup accelerator Y Combinator introduced the Simple Agreement for Future Equity (SAFE) to help streamline startup funding and save founders and investors' the time and money they would otherwise spend drafting one-off legal agreements.

Simply put, a Simple Agreement for Future Equity (SAFE) is a legal document between early-stage companies and investors for raising capital from investors in seed rounds.

The evolution of SAFEs, which have become the standard for startups setting out to raise seed money, shows the power, as the venture capitalist Ramy Adeeb has observed, of building something people want and then making it better.

How do SAFEs work?

Understanding how SAFEs work is important for founders and investors looking to raise or invest money while minimizing dilution. As the name suggests, it enables investors to fund startups in exchange for a promised equity in an amount to be determined in subsequent funding rounds or liquidity events.

The conversion is based on a valuation cap or discount rate, with some SAFEs offering both options. The valuation cap sets the maximum price at which the SAFE converts, while the discount rate is a percentage discount applied to the valuation of the next funding round. In the event of a liquidation, SAFE holders can either receive the original amount paid for the SAFE or convert it to the common stock based on the valuation cap

How post-money SAFE can overcome uncertainty

Though SAFEs gained wide acceptance, they left founders without a way to know precisely how much of their company they had sold. Nor did investors always end up with the equity percentage of ownership they had in mind when they invested.

To overcome this uncertainty, Y Combinator introduced a financing document called post-money SAFE, which, judging by its ubiquity, is a game changer because it enables a company and investor to determine right away how much ownership has been sold. It achieves that by, in effect, treating the capital raised via a SAFE as its own round.

A post-money SAFE relieves the burden on founders—who rightfully tend to be too busy building their product and winning customers—to calculate the dilution to their ownership that an investment will produce.

From experience working with founders the past two years, I know first-hand that calculating dilution using polynomial equations that are circular in nature will produce, at best, something less than 100% accuracy as a result of rounding errors.

Post-money SAFEs and dilution of ownership

Post-money SAFEs provide accuracy but come with a trade-off for founders. In their former incarnation, SAFEs diluted other SAFEs, which meant less dilution for founders. It also meant that calculating pre- and post-money valuation was complicated without a SAFE note calculator such as Note Genie.

While post-money SAFEs enable founders to know right away how much of their company they have sold, they alone experience the dilution of ownership. In short, post-money SAFEs do not get diluted by other SAFEs.

To balance dilution somewhat, holders of post-money SAFEs and founders will share dilution from the option pool in the Series A round of funding equally. For founders, that avoids an outcome in which they shoulder the burden of the option pool increase, which tended to be the case previously.

Consider this as well. Post-money SAFEs do not, by default, give investors the right to participate in subsequent rounds of funding. To address this, the parties to a post-money SAFE can negotiate a side letter that will confer the right to invest in Series A while maintaining their equity percentage ownership in the company. Because companies know who owns what, a post-money SAFE enables founders to calculate precisely how much equity to reserve for investment in their Series A by SAFE holders.

Using a pre and post-money valuation calculator for SAFEs

Thanks to improvements, the post-money SAFE marks a major upgrade from its predecessor in terms of transparency. Thanks to such SAFEs, founders now can map out a seed round, reward their earliest investors, and raise as much money as they could previously but with reduced risk of over-dilution.

Here at LTSE we look forward to learning how this plays out. We also know that in practice, a number of companies that plan to raise money via a post-money SAFE may have raised money previously via a pre-money SAFE. So the calculations of pre- and post-money valuation can complicate quickly.

Disclaimer: LTSE is neither a law firm nor provides legal advice. Before making decisions on matters covered by this post, readers should consult their legal adviser.

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