Demystifying SAFEs for Startup Funding

Whether you're a founder raising funds or an investor looking to back a venture, understanding SAFEs and how dilution impacts equity is crucial. Because if you don’t, both founders and investors risk ending up with less equity than anticipated.

Just one of many paths in the maze of terms and concepts, here’s a breakdown of SAFEs at a high level and how they fit into the world of startup funding.

What are SAFEs?

A SAFE—Simple Agreement for Future Equity—was introduced by Y Combinator in 2013 and is an investment vehicle designed to offer a flexible and straightforward approach for startups to raise capital without immediate dilution of ownership.

They are not debt, as they do not accrue interest or have a maturity date. Nor are they immediate equity, since the conversion to equity happens at a later financing round, often triggered by the startup raising a certain amount of capital or reaching a specific valuation.

Imagine you're trying to secure a VIP ticket for a highly anticipated movie that hasn’t been released yet. This VIP ticket will give you access to exclusive perks and a night to remember if the movie becomes a blockbuster hit.

You’re eager to attend this premiere and want to be part of something that could become iconic. However, the organizer can’t provide you with the VIP ticket right now because the event details are still being finalized. Instead, they offer you a voucher. This voucher is like an IOU—it guarantees you a VIP ticket in the future once everything is set, but you won’t get the actual ticket until the movie’s release.

The catch? Your VIP experience—and even getting the ticket—depends on the movie's success. If the movie flops, the voucher could end up worthless.

Off the red carpet (aka in non-movie terms), this is similar to investing in a startup where the valuation isn’t yet determined. You’re not getting equity immediately, but you’re promised equity when certain triggering events occur, like an equity financing round, an acquisition, or an IPO. The SAFE will convert into equity at that point, often based on the company’s success and valuation. If the company fails to reach those milestones, your investment might not yield the return you hoped for, and in some cases, could lose its value.

How Does a SAFE work?

Investment Vehicles Explained

SAFEs are one type of investment vehicle designed for simplicity as they were created specifically to address the challenges startups face during the crucial seed funding stage. Unlike traditional equity financing, which can be cumbersome and time-consuming, SAFEs do not require immediate valuation or repayment. Instead, they postpone the valuation discussion to a later funding round, enabling startups to focus on growth and secure capital quickly.

Simple Agreements for Future Equity

The name says it all—SAFEs are simple agreements for future equity. They are neither debt, as they do not accrue interest or have a maturity date, nor immediate equity, since the conversion happens at a later financing round. This conversion is often triggered by the startup raising a certain amount of capital or reaching a specific valuation.

By avoiding complex valuation methods and upfront negotiations, SAFEs get money into a company quickly and are efficient to use in an active/hot market or company.

Equity vs. Debt

Equity represents ownership in a company. SAFE holders are like early investors in a future priced financing; it is not debt. Unlike a loan, there’s no need to repay the invested amount. Instead, when the startup raises its next round of funding or gets acquired, a SAFE will convert into equity based on the terms agreed upon.

Why Are SAFEs Used for Startup Funding?

Speed and Simplicity

Startups often need funding quickly. SAFEs streamline the process, allowing startups to raise capital without extensive negotiations. This speed and flexibility can be critical for early-stage companies trying to capitalize on growth opportunities.

No Immediate Valuation Needed

Valuing a startup can be challenging, especially in the early stages. SAFEs allow startups to raise money without having to set a valuation right away. Instead, the SAFE converts into equity based on the valuation of a future financing round.

Attractive to Investors

For investors, SAFEs offer a chance to get in on the ground floor of promising ventures. The agreement of future equity can be a compelling incentive, especially when the startup has high growth potential.

Key Features of SAFEs

Conversion Terms

SAFEs typically convert into equity when a startup raises its next round of funding. The conversion terms are often set to be favourable to early investors, such as at a discounted rate compared to new investors or with a valuation cap that limits the price at which the SAFE converts into shares.

Valuation Cap and Discount

SAFEs may include a valuation cap, which sets the maximum valuation at which the SAFE will convert into equity. They might also offer a discount, providing an investor with a direct discount on the price per share they will ‎convert at, as compared to future equity investors.

No Repayment

A SAFE is not debt. Unlike debts that generally have an interest rate and a maturity date requiring repayment (such as convertible debt), SAFEs have neither.

The good and bad of it? SAFEs reduce financial pressure on startups by not requiring loan repayment, allowing them to use funds more freely for growth. This can increase their chances of success and ultimately benefit investors when SAFEs convert into equity. However, if the startup fails, investors may lose their entire investment, as the return is entirely dependent on the future success of the startup.

Pre-Money SAFEs vs. Post-Money SAFEs

There are two types of SAFEs: pre-money and post-money. Y Combinator introduced SAFEs in 2013 as pre-money SAFEs, and post-money SAFEs were introduced in 2018 to provide more clarity around ownership dilution and valuation by calculating the conversion terms based on the company's valuation after the SAFE investment is made, rather than before.

Pre-Money SAFEs

Pre-money SAFEs determine the investor's ownership stake before the new funding round's valuation is calculated. This means that the SAFE holder’s equity is based on the company’s valuation before the new round of investment. This approach can be beneficial for investors because it might provide a larger ownership percentage, as it does not account for the new money coming in.

Post-Money SAFEs

Post-money here considers, “After all the SAFEs have converted, what happens at that point?” Post-money SAFEs determine the investor's ownership stake after the new funding round's valuation and the new money are taken into account. This means the SAFE holder’s equity is calculated based on the valuation that includes the new investment.

This approach is often clearer for startups and investors as it provides a more transparent view of dilution and ownership percentages.

SAFEs offer a simpler, more flexible, and more efficient way for startups to raise funds and for investors to get a stake in emerging companies. With SAFEs, investing in startups becomes less about complex negotiations and more about believing in a company’s future potential. 

Whether you’re a seasoned investor or new to the startup scene, SAFEs can be a valuable tool in your investment toolkit—something we can help you build in our Investor Lab.

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*Please note that the information provided in this blog is for informational purposes only and should not be construed as investment or financial advice.