Equity financing can be complicated for early stage startups. Traditional equity financing like convertible notes come with complex legal terms and negotiations. Enter the SAFE – Simple Agreement for Future Equity. The SAFE framework aims to simplify early stage equity financing.

In this comprehensive guide, we’ll cover everything you need to know about the SAFE:

What is a SAFE and how does it work?

A SAFE stands for Simple Agreement for Future Equity. It allows startups to raise capital without setting a valuation upfront. With a SAFE, the startup gets capital now in exchange for giving the investors equity later when a priced round of financing happens.

Let’s break this down:

• Simple agreement – The SAFE document is relatively short and straightforward compared to traditional financing documents. This makes the legal process faster and cheaper.
• Future equity – Instead of getting equity now, investors get the right to future equity. The startup sets the valuation and issues equity in a future priced round.
• No valuation – Valuation is often a pain point in early stage financing. SAFE lets startups raise funds without agreeing on a valuation upfront.

Essentially, a SAFE allows startups to delay the valuation conversation until a future priced round. This helps startups test their ideas without getting bogged down in legal complexities of a priced round.

What are the benefits of using a SAFE?

There are several compelling benefits of using a SAFE for early stage financing:

• Simple and fast – SAFE docs are straightforward, usually around 10 pages. This makes the financing process much faster and cheaper than traditional equity rounds.
• No valuation required – Valuing pre-revenue startups can be challenging. SAFE lets founders raise funds without hard valuation conversations.
• Aligns incentives – SAFE holders benefit when the company raises its next round at a higher valuation. This incentivizes investors to add value and help the company grow.
• Easy to understand – SAFE is easier to grasp than complex equity instruments for founders and investors alike. This improves transparency and trust.
• Standardized docs – Using standardized SAFE docs vs custom convertible notes simplifies negotiations.
• Conversion flexibility – Details of SAFE conversion to equity can be tailored to company-investor needs.

For early stage startups, SAFE offers a faster, simpler way to raise risk capital without cumbersome term sheets and legal bills.

What are the downsides of using a SAFE?

However, SAFE financing isn’t ideal for every startup situation. Here are some potential downsides to consider:

• No immediate equity – Investors don’t get equity right away. For some investors, this may be a blocking point.
• Potentially diluted conversion – If the startup raises the next round at a lower valuation, SAFE holders get less equity compared to a capped convertible note.
• Less flexibility – SAFE terms are quite standardized. Companies have less room to tailor the agreement.
• No debt component – SAFE does not accrue interest like a convertible note. This reduces investor upside.
• Caps matter – Valuation caps become very important in SAFEs to protect against dilution. However, agreeing on caps can require negotiations.
• Less investor protection – SAFEs lack maturity dates and repayment options common in convertible notes. This exposes investors to more risk.

So while SAFE offers advantages like speed and simplicity, traditional convertible notes may be a better fit for startups wanting more control or investor protections.

Origins of the SAFE – how it came about

The SAFE was created in 2013 by Y Combinator (YC) – the influential startup accelerator.

YC wanted a standardized, simple financing document for its early-stage companies to use. At the time, most YC startups used convertible notes which required lengthy negotiations.

John Fogg and YC believed startups needed an easier option without the complexities of price and control.

The SAFE was born out of this need for a simplified early-stage funding document. YC published a standard SAFE template in 2013. Since then, SAFE has seen wide adoption by startups and investors.

However, it is important to note that SAFE is not a YC-exclusive instrument. Any early-stage startup can use it for fundraising.

Key terms in a SAFE agreement

While simpler than traditional financing documents, SAFEs still contain legal and financial terms that founders need to understand:

Investment amount – The total funds being invested by the SAFE holder into the startup.

Discount rate – This determines the discounted price at which SAFE converts into equity in the next round. The typical discount is 20%.

Valuation cap – The maximum pre-money valuation at which the SAFE will convert in the next round. This caps dilution for SAFE holders.

Right to future equity – The core of the SAFE. Gives investors the right to get equity shares in the future based on the next round’s valuation and discount rate.

Pro rata rights – Gives SAFE holders the right to participate in future financing rounds to maintain ownership percentage.

Equity financing – Defines a future “priced round” where SAFE converts. Ensures SAFE doesn’t accidentally convert during safe financings.

Liquidity terms – Optional terms allowing SAFE to be converted to equity outside of a priced round, like after a time period or acquisition.

Dissolution terms – Terms governing what happens if the company shuts down before the SAFE converts.

SAFE vs Convertible Notes – How do they compare?

Convertible notes have been the dominant form of early-stage financing for a long time. But the SAFE is giving convertible notes serious competition lately.

Let’s compare the two financing instruments:

SAFE	Convertible Notes
No maturity date or repayment requirement	Have defined maturity (typically 1-2 years) and repayment terms
No interest accrual	Notes accrue interest over time (typically 6-8%)
Standardized documents – less room for negotiations	Custom negotiated terms like discount, valuation caps, investor rights
Investors get no voting rights or board seats	Investors may negotiate for rights and board seats
Financing events that trigger conversion to equity are defined	Notes convert at maturity or upon equity financing usually
Converts only on equity financing that meets defined criteria (excludes convertible note/SAFE financings)	Converts at qualified financing which can be flexible to include convertible note or SAFE financings)
No debt or repayment obligation on startup	Note repayment obligation exposes startups to financial risk

The core tradeoff is this – SAFEs offer simplicity and standardization while convertible notes provide more control and investor protections.

Convertible notes better suit startups wanting maturity dates, interest rates, and flexible conversion terms. SAFEs are ideal for resource-constrained startups wanting fastest and easiest access to risk capital.

Guide to SAFE Valuation Caps

The valuation cap is an important component of SAFE agreements. It works exactly like a valuation cap in a convertible note.

The cap sets the maximum pre-money valuation at which SAFE converts to equity in the next round. Without a cap, SAFE holders bear full dilution risk.

Here’s an illustration of how valuation caps work:

• Startup raises $500K SAFE with 20% discount and $3M valuation cap
• In Series A, startup raises $2M at $6M pre-money valuation
• With no cap, SAFE value is $500K/($6M valuation + $2M investment) = 7.69% equity
• But valuation cap of $3M is triggered. So effective valuation is $3M cap + $2M investment = $5M
• Thus SAFE converts to $500K/($5M valuation) = 10% equity

In this example, the valuation cap saved SAFE holders from 2.31% extra dilution.

Typical SAFE caps range from 50-100% of the current startup valuation. Setting caps too high can deter future investors.

Coming to an agreement on valuation caps requires the same challenging conversations SAFEs are designed to avoid. Some startups use uncapped SAFEs with only discounts to keep things simple. Others make the cap a fixed multiple of the SAFE investment amount. Many simply align caps with their perceived current valuation.

Valuation caps remain an important tool for SAFE holders to limit dilution in future priced rounds. Founders should educate themselves on how caps work before accepting capped SAFEs.

Drafting SAFE Documents – What startups need to know

While SAFEs utilize standardized templates, startups still need to understand the key components involved in drafting effective SAFE agreements.

Here’s what startups should focus on:

1. Use established templates – Most SAFEs are based on open-source templates like the YC SAFE and Series Seed documents. Custom drafting usually isn’t necessary.

2. Set the investment amount – The total capital being invested via the SAFE.

3. Select discount rate – Typically 20%. Communicates estimated increase in valuation until the next round.

4. Define valuation cap – Critical term dictating conversion. Keep the cap reasonable but high enough to get investors interested.

5. Pick conversion triggers – Equity financing is standard. Optionally include terms for conversion upon sale, IPO, or maturity date.

6. Check investor rights – Standard SAFEs give minimal rights. Watch out for pro rata and information rights.

7. Clean up exhibits – Remove unnecessary exhibits from the template based on your financing situation.

8. Define key company info – Properly identify the company name, jurisdiction, incorporation details, and founders.

Startups should engage legal counsel to ensure the SAFE meets local regulations and founder’s interests. But the drafting process is far simpler than negotiating complex financing terms.

SAFE Financings: Process, Effective Practices, and What to Avoid

Once startups decide to use a SAFE, how should they actually execute the SAFE financing? Here are some tips:

Process

• Start with an open-source SAFE template
• Make revisions based on investor feedback
• Send final SAFE doc for e-signing along with investment instructions
• Collect signed SAFEs and investments from each investor
• Keep a cap table to track SAFEs and potential future equity

Effective Practices

• Disclose all material info to investors (traction, KPIs, risks etc)
• Align expectations on valuation caps and future funding needs
• Build relationships with investors likely to participate in future rounds
• Keep legal costs low by using standardized templates

What to Avoid

• Making complex custom edits to SAFE docs
• Accepting complicated investor demands around rights and terms
• Opaque cap setting without sufficient context on company valuation
• Claiming SAFE valuations as definitive pre-money valuations

With some diligence around alignment and transparency, startups can leverage SAFEs to quickly amass risk capital and focus on execution.

Key Takeaways and Summary

For early stage startups, the SAFE offers a faster, cheaper alternative to traditional equity financing:

• No valuation requirement – Enables raising funds without complicated valuation discussions.
• Simplified docs – Standardized forms cap legal bills and accelerate financing.
• Future equity – Investors get equity at next round, allowing startups to defer dilution.
• Aligned incentives – SAFE holders benefit from growth leading to higher future valuations.
• Investor risk – Lack of debt component and investor protections means more risk for investors.
• Capped vs uncapped – Valuation caps add complexity but limit dilution.
• Stage appropriate – SAFE best suited for pre-seed to seed stage companies before serious traction.

While not a perfect solution, the SAFE framework simplifies the chaotic early stage fundraising process for many startups. However, it is critical to understand the nuances before committing to a SAFE-based financing.