How SAFEs Work for Early-Stage Startups

For early-stage startups seeking initial funding, a Simple Agreement for Future Equity (SAFE) has become a popular and efficient financial contract. Pioneered by the renowned accelerator Y Combinator in 2013, SAFEs offer a simpler option than traditional equity financing. 

In this blog post, we’ll cover:

How SAFEs Work: A Convertible Instrument

At its core, how a SAFE works revolves around its nature as a convertible instrument. Unlike a direct purchase of equity, when an investor provides capital through a SAFE, they are essentially buying the right to receive equity in the company at a future point. This conversion into equity isn’t immediate; it’s triggered by a specific event. 

The most common event that dictates how a SAFE works and converts is a priced equity round. This occurs when the startup sells shares of its equity to new investors at a pre-determined price per share. However, other events, such as an acquisition or an Initial Public Offering (IPO), can also trigger the conversion of a SAFE into equity.

Why Founders Choose SAFEs: Understanding the Benefits

Understanding how SAFEs work also means recognizing their advantages for founders:

1. Simplicity & Cost-Effectiveness: SAFEs offer a key advantage: simplicity. Unlike the lengthy and complex negotiations of traditional equity rounds, SAFEs have fewer terms to work through. This reduces paperwork and significantly lowers legal costs, letting founders concentrate on building their companies.
2. Flexibility in Fundraising: How SAFEs work allows for greater flexibility in fundraising. Although standard SAFE templates are available, companies and investors can tailor them to their specific needs. This flexibility allows for “rolling closes,” where a company can secure investments through multiple SAFEs over time at different valuations. Priced equity rounds, in contrast, usually require a complete restart for each new fundraising effort.
3. No Upfront Valuation Needed: In the early stages, accurately valuing a new startup is often tough. A significant benefit of how SAFEs work is that they avoid this immediate need for a precise valuation. Instead, the conversion price later on is determined by mechanisms like a valuation cap or a discount, which we’ll explain in more detail later
4. Not Debt, But Future Equity: It’s important to know that SAFEs aren’t debt like convertible notes. They don’t accrue interest or have a repayment deadline. Instead, a SAFE investment is a bet on the company’s future, with the expectation of becoming equity later.

Key Terms That Define How SAFEs Work

To fully grasp how SAFEs work, it’s important to familiarize yourself with their common terms:

Valuation Cap: The valuation cap is the maximum company valuation used when their SAFE converts to equity during a future funding round. This protects early investors by ensuring a favorable conversion price compared to new investors if the company’s valuation skyrockets.

• Example: Company ABC has a SAFE investor with a $5M valuation cap. When Company ABC raises a new round at a $10M valuation, the new investors pay the $10M price, but the SAFE investor’s shares are calculated as if the valuation were only $5M. This means the SAFE holder gets more shares for the same investment.

Discount: Often used alongside or instead of a valuation cap, a discount gives SAFE investors a lower price per share than new investors in a future funding round. It’s another way how a SAFE works to reward early belief in the company.

• Example: Using the same scenario, a 20% discount on a $10M valuation means the SAFE holder’s conversion price is based on a $8M valuation. If both a valuation cap and discount exist, the investor usually benefits from whichever term gives them a better deal.

Pro Rata Rights: When a SAFE converts to equity, the investor receives shares, but these shares can be diluted by new investments. Pro rata rights, often detailed in side letters, dictate how a SAFE works for existing investors in later funding rounds. They give these early investors the option to invest more money to maintain their initial percentage ownership.

• Example: A SAFE investor expects to own 10% initially. After new investment dilutes their stake to 8%, pro rata rights allow them to invest more at the new valuation to get back to their 10% target.

Most-Favored Nation (MFN): The MFN clause acts as a safety net for early SAFE investors. It states that if the company later issues SAFEs with better terms (like a lower valuation cap), previous investors with MFN status automatically get those more favorable terms applied to their original SAFE. This is a key aspect of how SAFEs work to protect early backers.

• Example: An early investor has a SAFE with a $5M cap. If a later investor gets a $3M cap, the MFN clause means the first investor’s cap also drops to $3M.

Pre-Money vs. Post Money SAFE: A common point of confusion for founders is the difference between these two types, which significantly impacts how SAFEs work and the resulting ownership.

• Post-Money SAFE: This clearly defines the investor’s ownership percentage after their investment and after accounting for all other SAFEs and convertibles, but before any new money comes in during the next priced round. It offers a more immediate understanding of the ownership stake.
  • Example: A $1M investment in a post-money SAFE with a $5M cap means the investor expects 20% ownership ($1M/$5M) before the next funding round.
• Pre-Money SAFE: Here, the investor’s ownership isn’t as immediately clear. The conversion depends on the company’s valuation before the new money and before the conversion of the SAFE itself. It also factors in the full option pool. This makes the final ownership percentage less predictable than with a post-money SAFE.
  • Example: A $1M investment in a pre-money SAFE with a $5M cap won’t guarantee 20% ownership, as other SAFEs and the option pool will affect the final calculation.

How SAFEs Convert: A Step-by-Step Guide for Founders

Want to see exactly how those SAFE terms play out when it’s time to convert to equity? Let’s dive into a practical, step-by-step guide exploring different examples.

Example 1: The Impact of a Valuation Cap

_{Figure 1. Outlines the initial setup for the step-by-step guide and illustrates how a valuation cap works.}

Imagine your startup has an initial capitalization of 10,000,000 shares, with you owning 5,000,000 and other founders holding the rest. The existing option pool is fully allocated.

You secure two post-money SAFE investments of $2,000,000 each, both with a $20,000,000 valuation cap and a 20% discount. Later, your startup achieves a $40,000,000 pre-money valuation and raises a new $10,000,000 investment. You also aim for a post-money option pool of 10%.

The Conversion Process:

1. Calculate the Post-Money Valuation
   • Pre-Money Valuation + New Investment = Post-Money Valuation
     • $40,000,000 + $10,000,000= $50,000,000
2. Determine New Investor Ownership
   • New Investment / Post-Money Valuation = New Investor Ownership
     • $10,000,000 / $50,000,000 = 20%
3. Calculate SAFE Investor Ownership (Based on Valuation Cap)
   • With a $20,000,000 valuation cap, each SAFE investor’s ownership is calculated as if the company were valued at $20,000 after their investment:
   • Principal / Valuation Cap = Individual SAFE Ownership
     • $2,000,000 / $20,000,000 = 10%
       • This suggests each SAFE investor should own 10% of the post-SAFE capitalization.
4. Calculate Shares Issued to SAFE Investors
   • Figure 1 shows that each SAFE investor receives 1,250,000 shares. We can verify that this satisfies the 10% ownership requirement by dividing the 1,250,000 shares by the total capitalization after all the SAFEs convert but before the new money comes in:
     • 1,250,000 shares / (10,000,000 + 1,250,000 + 1,250,000 shares) = 10%
5. Impact of Dilution
   • However, due to the new investors (20%) and the option pool top-up (10%), the SAFE investors’ ownership is diluted by 30%.
6. Actual SAFE Investor Ownership
   • Total Shares After SAFE Conversion
     • 10,000,000 + 1,250,000 + 1,250,000 = 12,500,000
   • Individual SAFE Investor Ownership
     • 1,250,000 / (12,500,000 + new shares for new investors and options) < 10%
   • The SAFE investors end up with 7% ownership.
7. Discount vs. Valuation Cap
   • The SAFE discount does not affect the calculations since the benefit of the post-money valuation cap ($20,000,000 vs. $50,000,000) is far better than what the discount provides (20%).
8. Final Ownership Breakdown
   • The remaining founders end up with 56% after accounting for the new investors (20%), the option pool (10%), and the SAFE holders (14%).

Example 2: The Power of a Discount

_{Figure 2. Illustrates how a discount can alter the calculation.}

Let’s revisit the previous example, but now the first SAFE holder has a significant 90% discount, while the second retains the original terms. This steep discount provides the SAFE investor with a significantly favorable conversion price by reducing the $1.15 price per share paid in the round.

The Conversion Process

1. Calculate the Conversion Price for the Discounted SAFE
   • Price Per Share x (1 – Discount) = Conversion Price
     • $1.15 x (1 – 0.90) = $0.115/share
2. Calculate Shares Issued to the Discounted SAFE Holder
   • Principal / Conversion Price = Shares
     • $2,000,000 / $0.115 per share = 17,391,304 shares
3. Impact on Ownership
   • With significantly more shares, the first SAFE holder’s ownership dramatically increases at a 40% stake in the company (17,391,304 shares / 43,478,260 shares). This increase comes primarily at the expense of the founders.
   • The second SAFE investor, the new investors, and the option pool all retain their original stakes.

Example 3: Maintaining Control with Pro Rata Rights

_{Figure 3. Pro rata rights example.}

Consider the initial setup again. Now, the first SAFE investor has pro rata rights, allowing them to invest further in the equity round to maintain their ownership percentage.

The Conversion Process

1. Initial Conversion
   • The first SAFE converts based on either the valuation cap or the discount (whichever is more favorable). Let’s assume it converts to maintain a 7% stake as in Example 1.
2. Exercising Pro Rata Rights
   • The first SAFE investor can now purchase additional shares in the new funding round to bring their total ownership back to their initial target (10%).
3. Pricing of Pro Rata Shares
   • These additional shares are purchased at the new equity round price ($2.80/share), not the SAFE conversion price.
4. Source of Pro Rata Shares
   • The additional 3% ownership for the first SAFE investor (to go from 7% to 10%) comes from the new investors’ allocation, reducing their stake (from 20% to 17% in the original example), not the founders’.

Example 4: Leveraging the Most-Favored Nation (MFN) Provision

_{Figure 4 illustrates the value of holding an MFN provision}

Two SAFE investors have different valuation caps: the first at $20,000,000 and the second at a more favorable $15,000,000. The second SAFE converts based on the lower cap, resulting in higher ownership percentage (9.3%).

The Conversion Process

1. MFN Triggered
   • The first SAFE investor has an MFN provision, meaning they are entitled to the better terms offered to later SAFE investors.
2. Term Adjustment
   • The first SAFE’s valuation cap is adjusted down to $15,000,000, matching the second SAFE investor’s terms.
3. Increased Ownership
   • Consequently, the first SAFE investor also receives a larger share of the company, also ending up with 9.3% ownership.
4. Impact on Founders
   • Unlike pro rata rights, the additional shares granted due to the MFN provision typically come from the founder’s equity, diluting their ownership down to 51.4%, which is 4.6% less than before (2 x 2.3% due to the increase from 7% to 9.3%).

Example 5: The Difference Between Pre-Money and Post-Money SAFEs

_{Figure 5 shows what happens if a pre-money SAFE is used instead of a post-money SAFE.}

In this example, the first SAFE investor holds a pre-money SAFE, while the second has a post-money SAFE (as in the initial examples).

The Conversion Process

• Post-Money SAFE Conversion (Investor 2)
  • As seen before, the post-money SAFE converts based on the post-money valuation cap, resulting in 7% ownership.
• Pre-Money SAFE Conversion (Investor 1)
  • The conversion price for a pre-money SAFE is calculated differently.
  • Pre-Money Valuation / (Pre-Money Shares + New Option Pool Shares) = Conversion Price
    • $20,000,000 / (10,000,000 + 1,774,194) = ~$1.699/share
• Shares Issued to Pre-Money SAFE Holder
  • Principal / Conversion Price = Shares
  • $2,000,000 / $1.699 per share = ~1,177,419 shares
• Ownership Comparison
  • The pre-money SAFE holder ends up with a slightly lower ownership stake (6.6%) compared to the post-money SAFE holder (7%). The difference in equity is typically allocated to the founders.

Managing SAFEs with Mantle

While SAFEs simplify fundraising, managing them—especially multiple SAFEs with varying terms—can become complex. That’s where Mantle comes in.

Mantle allows you to:

• Issue SAFEs: Quickly generate and send SAFEs to investors with customizable terms.
• Track Investments: Monitor all SAFE agreemeents in one place, ensuring transparency and organization.
• Update the Cap Table: Automatically update your cap table in real-time as SAFEs convert, giving you a clear picture of ownership and dilution.
• Model Future Scenarios: Use Mantle’s scenario modeling tools to simulate future funding rounds and understand potential impacts on ownership.

Conclusion

SAFEs are a powerful tool for early-stage fundraising, offering simplicity and cost savings. However, understanding key terms and managing them effectively are crucial to maintain clarity and control over your company’s equity.

Ready to streamline your SAFE management? Sign up for Mantle today and take the hassle out of fundraising.