Understanding A SAFE Contract

Understanding A SAFE Contract

What startups should know when negotiating with investors.

Silicon Valley’s Y Combinator has been a trailblazer in many ways, one of which is pioneering the SAFE contract for startups.

SAFE stands for Simple Agreement for Future Equity. It is a smart way for startups to raise debt-free seed capital. Startups enter into agreements with investors for receiving a certain amount of money today, in exchange for shares that the investor receives at a later date.

The later date in post-money SAFEs is typically the date on which the startup raises a priced equity round, usually their Series A. Standard SAFE agreements also provide for other major events, such as founders selling the company or shutting shop.

SAFEs are easier to execute than traditional priced equity rounds, especially with Y Combinator’s SAFE contract templates. While a SAFE contract is technically supposed to remain unchanged from its original form, it was designed for the United States legal system and may need adjustments when applied elsewhere. Knowing a few key terms can give startups the edge in negotiating a mutually beneficial SAFE contract.

The Valuation Cap

Knowing why a ‘post-money’ SAFE exists requires a slight brush up on SAFE history, but first, it’s important to understand the valuation cap.

Investors and founders negotiate a valuation cap at which the SAFE converts. When the priced round (or any other triggering event) occurs and the valuation of the startup is higher than the valuation cap, the SAFE converts at the agreed upon capped value.

However, if the valuation of the startup is lower than the cap, the SAFE then converts at the actual valuation, so investors end up owning more of the company–their investment now entitles them to a higher stake.

Post-Money SAFEs

A quick history lesson: when SAFEs came out in 2013, startups were raising much smaller seed or angel rounds prior to a priced round. This did not have a major impact on their valuations. With time, however, seed rounds grew to hundreds of thousands of dollars, and had to be accounted for when valuing a startup.

A post-money valuation simply means the total of the pre-money valuation of the company (or the valuation before any priced round was raised) and any new money raised, including via SAFEs.

The post-money valuation cap is one of the more popular types of SAFEs, but there are also discount SAFEs (where the investor receives shares based on a discount instead of a valuation cap), valuation cap and discount SAFEs (where both the valuation cap and discount are considered), or Most Favored Nation (MFN) SAFEs.

Instead of a valuation cap or discount, MFN SAFEs allow investors to adopt the terms of another investor from whom the startup raises funds, if they find those terms favorable. This kind of SAFE comes into play when a startup is especially young and difficult to value.

Pro Rata Rights

Post-money SAFEs come with the optional side clause that gives investors pro rata rights, or rights to purchase additional shares in the priced financing round where the SAFE converts. Pro rata share rights are issued proportionally based on how many shares were issued to the investor on conversion of the SAFE. Investors have the right to purchase only as many additional shares as this ratio allows.

SAFEs Can Get Tricky

The thing about a SAFE is that it dilutes ownership of the startup–but not today. For instance, when founders enter into multiple SAFEs or issue shares, the increasing dilution of ownership tends to escape their scrutiny. Y Combinator partner Kirsty Nathoo provided a common example: by giving out shares via an employee stock ownership plan (ESOP), as many startups do, founders dilute their ownership by a certain percentage.

At this point, SAFE investors still have rights to a specific number of pre-dilution shares, so when the SAFE converts, it changes the capitalization table, and founders end up forfeiting more than they expected.

Technicalities such as these can lead to startup founders finding themselves in a quagmire where they have given up more ownership than they anticipated. Keeping tabs on the cap table becomes imperative when SAFEs or any other convertible instruments are issued. The smart thing to do for founders who cannot do the math, is to hire a lawyer who can.

Header image by Helloquence on Unsplash

SHARE THIS STORY

Share on facebook
Share on twitter
Share on linkedin
Share on email
Sharon Lewis
Sharon is a Staff Writer at Jumpstart

RELATED POSTS

Mental Health Tips for When You Get Back in the Office

Mental Health Tips for When You Get Back in the Office

The COVID-19 pandemic has brought a lot of challenges for employees working from home. As we are fast approaching the post-pandemic world, we have to start getting accustomed to heading back to the office again. No doubt, it is going to be difficult adjusting to the long-forgotten habit of getting ready early in the morning, putting on your finest work clothes, working till 7pm in your suffocating cubicle and dealing with horrible bosses and gossipy colleagues face to face.

Top Three Online Job Portals in China for English-Speakers

Top Three Online Job Portals in China for English-Speakers

China is a fast-growing economy and currently boasts the second-largest economy in the world behind the United States. Many people from around the world have tried searching for jobs and achieving career success in the country. The majority of English-speaking people in China find work in multinational companies that are mostly located in metropolitan Shanghai and Beijing.

How Does a Startup Become a Unicorn

How Does a Startup Become a Unicorn

In the startup world, a unicorn refers to any startup with a valuation of over US$1 billion. Companies like Airbnb and Netflix fall under the unicorn category. As of 2021, there are 650 unicorns in the world with a cumulative valuation of US$2,173 billion.

Meet the Young Woman Who Saved Kenya’s Plastic Waste Problem

Meet the Young Woman Who Saved Kenya’s Plastic Waste Problem

Kenya has a huge plastic waste problem. A 2015 report found that the Kenyan capital Nairobi produced around 400 tons of plastic waste every day. Yet, less than half of that had been recycled. Despite outlawing single-use plastics in 2017, the country is still drowning in them. The Dandora landfill, located in the heart of the Nairobi slums, currently receives more than 2000 metric tons of waste daily.

How Can Your Company Become More Energy-Efficient

How Can Your Company Become More Energy-Efficient?

Countries and companies are consuming too much energy today. The abrupt power cuts in China are a testimony to that. The country was forced to cut power across factories and towns to meet their energy goals. Energy efficiency—using less energy to do more—does not have to be this challenging and cumbersome, not for large corporations or startups.

Cyberport Venture Capital Forum

How Will Humans and Technology Interact in the Next Decades?

While the world has witnessed a rapid digitalization of our everyday life in the course of the pandemic, attention has been brought to the debate that has long been around–how should humans and technology interact? And how do we prepare for new developments? In response to this, Dr. David Siegel, Co-Chairman and Co-Founder of financial sciences company Two Sigma.