Reading: Simple Agreement For Equity (SAFE)

The first important negotiation point is whether the SAFE includes a so-called Valuation Cap. The Valuation Cap indicates the maximum firm value at which the SAFE will be converted into company equity in the priced financing round.

Below, we illustrate the mechanics of the Valuation Cap in a priced subsequent financing round (issuance of Preferred Stock) as well as the "liquidation" of the company. For your convenience, we have compiled a simple online tool that allows you to quickly assess the implications of these financing events in the presence of a SAFE.

Conversion of SAFE into SAFE Preferred Stock

Example 1:

• Suppose an investor has purchased a SAFE for $ 200'000. The Valuation Cap is set at $ 4 million and the firm has 5 million shares of common stock outstanding right before the priced financing round.
• Now the firm issues 1 million shares of Preferred Stock at a price of $ 2 each. The issuance of this Preferred Stock automatically triggers the conversion of the SAFE into SAFE Preferred Stock.

How many shares will the SAFE investor receive? Put differently, at what price will the SAFE be converted into SAFE Preferred Stock?

The SAFE limits the maximum valuation for conversion to $ 4 million (pre-money valuation). Given 5 million shares outstanding right before the financing round, the maximum conversion price that is implied by the Valuation Cap is $ 0.8:

Maximum SAFE Conversion Price = \( \frac{\text{Valuation Cap}}{\text{Number of shares outstanding}} = \frac{4}{5} \) = 0.80.

Because this conversion price is lower than the price at which the new investors purchase preferred stock ($ 2), SAFE investors will opt to convert their investment at a price of $0.8 and, consequently, receive 250'000 shares of SAFE Preferred Stock:

Shares of Safe Preferred Stock = \( \frac{\text{SAFE Amount}}{\text{Conversion Price}} = \frac{200'000}{0.8} \) = 250'000.

Consequently, the firm's capitalization table after the preferred stock financing round will be, on a fully diluted basis:

Note that, without the Valuation Cap (and no discount), the SAFE would be converted into SAFE Preferred Stock at the same price as the Standard Preferred Stock, namely $ 2. Consequently, the SAFE investor would only receive 100'000 shares of SAFE Preferred [= 200'000/2], which would reduce her ultimate ownerhip in the company to 1.6% [= 100'000/6'100'000].

Example 2:

Now suppose the same firm with the same SAFE (200'000 investment, Valuation Cap of 4 million) issues preferred stock at a price of $0.5 each. In this situation, the maximum SAFE conversion price of $ 0.8 exceeds the issue price of the standard preferred. SAFE investors will therefore receive the same deal terms as the investors in the standard preferred and, consequently, convert their investment at a price of $ 0.5 into 400'000 shares of SAFE Preferred.

Discussion

A Valuation Cap is an effective way for seed investors to protect against excessive dilution in future rounds of financing. By limiting the price at which the SAFE investment will be converted into company equity, investors can make sure that they participate in the upside if the firm develops exceptionally well between the seed investment and the first priced financing round. Thereby, they receive compensation for the extra risk they took by participating in the seed round as well as for the fact that many of their seed investments will not make it to a priced round.

From the mechanics of the Valuation Cap it is clear, that SAFE investors have an incentive to negotiate for a low Valuation Cap, whereas the founders have a preference for a high Valuation Cap, as a high cap means less dilution of the founder's shares. 

Valuation Cap and Company Liquidation

In the case of liquidation before a priced financing round, SAFE investors can choose between having the SAFE purchase amount returned (1 time liquidation preference) or having the investment converted into common stock.

Example 3:

Suppose an investor has purchased a SAFE for 300'000 with a Valuation Cap of 5 million. There is a total of 1 million shares of common stock outstanding (excluding unallocated shares in option pools). Another company is interested in buying the firm's equity for a cash consideration of 20 million. What will be the value allocated to the SAFE investor?

The SAFE investor can have the capital returned ($ 300'000) or convert the shares into common stock. Given a Valuation Cap of 5 million and 1 million shares outstanding, the Liquidity Price of the SAFE is $5 per share:

Liquidity Price = \( \frac{\text{Valuation Cap}}{\text{Shares outstanding}} = \frac{5'000'000}{1'000'000} \) = 5.

Consequently, the SAFE will be converted into 60'000 shares of common stock:

Shares of Common Stock to SAFE = \( \frac{\text{SAFE Amount}}{\text{Liquidity Price}} = \frac{300'000}{5} \) = 60'000.

After the conversion, there will consequently be a total of 1'060'000 shares outstanding [= 1'000'000 + 60'000]. Given a purchase price of 20 million, the acquirer will therefore pay $18.87 per share of common stock:

Takeover Price per Share of Common Stock = \( \frac{\text{Deal Value}}{\text{Shares outstanding}} = \frac{20'000'000}{1'060'000} \) = 18.87.

Since the SAFE investors have received a total of 60'000 shares, the value the capture will be 1.13 million:

Value to SAFE Investors = Takeover Price per Share × Shares to SAFE = 18.87 × 60'000 = 1'132'075.

SAFE investors will therefore opt to convert their shares into common stock, as the associated payout of 1.13 million exceeds the liquidation payout of 300'000 by far.

Example 4:

Now suppose the best takeover offer for the same firm is $ 1 million only. How much will the SAFE shareholders receive? To find out, we can replicate the analysis from Example 3 with the updated deal consideration.

If the SAFE investor has the purchase price returned (liquidation preference), she will receive a cash consideration of $ 300'000. In contrasts, if she opts for a conversion into common stock, the consideration will only be 56'604. The latter result can be calculated as follows:

• The Liquidity Price is still $5, so that the SAFE would convert into 60'000 additional shares of common stock
• With a deal consideration of 1 million, the Takeover Price per Share of Common Stock would therefore be $ 0.9434 [= 1'000'000 / 1'060'000].
• The SAFE investors would therefore capture a value of 56'604 [= 0.9434 × 60'000] if they converted the SAFE into common stock.

It is therefore better for the SAFE investor to have the purchase price returned. The implication for the common stock holders is that their cash consideration will drop to 700'000, namely the purchase amount of 1 million net of the liquidation preference of the SAFE. Given 1 million shares of common stock outstanding, this implies a takeover price of $ 0.70 per share of common stock.

Consequently, thanks to the liquidation preference, the SAFE investor can capture 30% of the total deal value!