Should You Use SAFE For Your Startup? Full Guide

SAFE (short for “Simple Agreement for Future Equity”) is a financial instrument used by investors to invest in early-stage startups. Since their creation by Y Combinator in 2013, SAFE has become increasingly popular for their simplicity, both for startups and investors.

Because SAFE was originally designed as an alternative to convertible notes, both share many characteristics, yet they’re also very different.

So what exactly is SAFE? Why is it so popular amongst early-stage startups? Should you use it as a founder? In this article we’ll tell you everything you should know about SAFEs and more especially:

SAFE: What Is It?

SAFE (short for “Simple Agreement for Future Equity”) is a financial instrument that allows investors to invest in early-stage startups. It has been created in 2013 by the YCombinator team as an alternative to another similar instrument: convertible notes. For more information on convertible notes for startups, read our full guide here.

SAFE gives investors the right to convert their SAFE notes into shares at a future fundraising (priced) round. Therefore, when investors invest with SAFE, they aren’t given shares yet. Instead, they get a warrant: a right to convert their warrant (SAFE) into shares at the next fundraising round.

The number of shares a SAFE investor is allowed to convert its SAFE notes into is a function of 3 factors: the discount rate, valuation cap and the valuation of the business set at the future priced round.

As such, as we’ll see later, SAFE is a very attractive form of financing both for investors and startups. Indeed, it’s really easy to issue SAFE notes, and access to funds is much faster vs. priced equity rounds.

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What’s The Difference Vs. Convertible Notes?

If you’re already familiar with convertible notes, you could be asking what’s the difference vs. SAFE.

How are they similar?

Both SAFE and convertible notes are financial instruments that give investors right to a number of equity shares at the next priced equity round.

The number of shares is determined at the next priced equity round based on a number of terms: the discount rate, valuation cap and the valuation.

How are they different?

Unlike convertible notes (or convertible debt), SAFE isn’t debt.

Therefore, unlike convertible notes, SAFE doesn’t have a maturity date nor accruing interest rate, which makes it even more attractive and simple to use for startups.

Unlike SAFE, convertible notes indeed have:

  • A maturity date: the startup is due to either convert the convertible note into equity, or repay it to investors by a certain date. If the startup fails to do so, it defaults (and unless an agreement is found, goes bankrupt)
  • An interest rate: when the startup swaps the convertible note into equity at or before maturity, it does so with accruing interest. For example, a $100k convertible note with 10% annual accruing interest would be worth $110k in a year. Therefore, we would use $110k instead of the $100k to determine how many shares the investor should get

For a full list of the 6 differences between SAFE and convertible notes, read our article here.

SAFE: Key Terms

SAFE are simple financial instruments with 2 key terms only:

Valuation cap

The cap sets the maximum price at which the notes will convert into equity. It is designed to protect startups from excessive ownership granted to investors in the future.

Indeed, because the valuation is not yet set when SAFE notes are issued, startups cap the amount of equity they need to give away in the future, in case the next priced round result in a low valuation. Confusing? Let’s use an example:

Let’s assume SAFE investors invested $1 million in a startup. Later, the post-money valuation at the next funding round is $5 million. Assuming a $1 share price for simplicity, SAFE investors get 25% equity (1,250,000 shares) at $0.80 a share.

Assuming the valuation is instead $10 million, the startup will only have to give away 12.5% equity instead (1,250,000 shares / 10,000,000 total shares) which is obviously better for startups and their founders.

This is where valuation cap is useful: it sets the minimum valuation at which the debt converts into equity to protect the startup from significant dilution. In our example, assuming a $10 million valuation cap, the startup would only have to give away a 12.5% maximum of equity. Logically, the lower the cap, the better for the investor.

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Discount rate

SAFE investors (sometimes) get an additional discount on the price of the shares. Discount rates are more common for convertible notes investors.

The discount compensate them for the risk they took by investing earlier.

For example, let’s assume:

  • A $200k SAFE with a 20% discount rate
  • The company raises money at $1 per share at the next priced equity funding round

Therefore, instead of getting 200,000 shares, SAFE investors get 250,000 shares ($200k / $0.80 per share).

Since its creation in 2013, SAFE notes have become very popular amongst startup founders and investors. There’s a number of reasons for that:

Access to funds is quicker

Like convertible notes, and unlike equity, SAFE are simple instruments that can be issued in a matter of days. The legal documentation is indeed very light. This ensures startups can actually receive the funds really fast.

SAFE delays valuation

Because SAFE (and convertible notes) rely on the next priced equity round to determine valuation (and therefore the number of shares to issue accordingly), it delays a long process of due diligence and negotiation that can sometimes take weeks.

As such, access to funds is quicker, and it saves both investors and founders expensive legal costs.

SAFE don’t need to be repaid

Unlike convertible notes, startups that raise SAFE don’t have an obligation to repay it in case it doesn’t convert to equity.

This is really attractive for startups, all the more that SAFE don’t come with a maturity date nor interest.

As such, startups can sit on SAFE notes for a very long time theoretically. Unlike convertible notes that usually come with a 12-18 months maturity, they don’t have to do a priced equity round within a specified timeframe.

Therefore, SAFE are also riskier vs. convertible notes both for investors. Indeed, they aren’t debt. In case of a bankruptcy, SAFE investors don’t have priority over the assets of the business (unlike convertible debt).

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SAFE: How To Limit Dilution For Founders

SAFE have become increasingly popular for their simplicity. Yet, like convertible notes, as a founder you must be well aware of dilution risks before signing a SAFE. If not done correctly, you could lose substantial ownership, and eventually control of your business.

Startups swap SAFE into equity at the next priced equity round. This means startups have to issue new shares, with inevitably leads to dilution to original investors and founders.

The problem with SAFE (and convertible notes) is that valuation isn’t yet set when then are issued. Therefore, if the valuation cap isn’t set correctly (more on that above), dilution can be disastrous.

Therefore, to avoid excessive dilution, make sure to:

  • Limit the discount rate. Most SAFEs these days don’t even have a discount rate. Logically, the lower the discount rate, the better for founders.
  • Set a (high) valuation cap. As explained above, the valuation cap is designed to protect startups vs. excessive dilution if the next priced equity round results in a low valuation. The higher the valuation cap, the better for founders

For more information on how to limit equity dilution for founders, read our article here.