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.
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.