Reading: Simple Agreement For Equity (SAFE)

The SAFE offers many positive features compared to "traditional" financing instruments, which is why it is not surprising that it has been gaining traction in the startup financing scene. These advantages include:

• In its standard form, only one deal element has to be negotiated, namely the Valuation Cap. The SAFE should therefore reduce legal fees and other direct and indirect costs of term sheet negotiations.
   
• A SAFE is not a debt instrument. The payments of a SAFE are linked to a liquidity event. Absent a liquidity event, they cannot be legally enforced. Unlike a convertible note, a SAFE does therefore not create the threat of financial insolvency.
   
• A SAFE has no maturity date. Therefore, the SAFE amount does not have to be repaid (unless in the case of a liquidity event), there is no refinancing risk, and the founders don't have to deal with typical debt-related issues such as the renegotiation of maturity dates or the adjustment of interest rates.
   
• A SAFE is much more flexible than Preferred Stock. There is much less of a need to coordinate all investors in a single close. Instead, severals subsequent rounds of SAFEs can be orchestrated, and all of them then convert into Preferred Stock at the first significant (and priced) financing round.

Still, it is important to be careful when negotiating SAFEs. 

• As long as the firm is doing well, the SAFE will convert automatically into preferred stock during the first priced financing round. It is therefore indispensable that the founders understand what preferred securities are and what kind of deal terms they will almost inevitable face at a future date. This is why the preceeding chapters on term sheet negotiations are relevant also for founders who want to issue SAFE notes.
   
• Related, since SAFE will convert into equity, it will eventually almost inevitably dilute the ownership structure. 
   
• SAFE notes are excellent instruments to finance the company to reach a significant milestone. In contrast, using SAFEs to postpone a priced financing round (hoping for higher valuations) or to avoid having to deal with "professional" investors, could harm the firm in the medium to long run. The reason is that a large number of oustanding SAFE notes might lead to significant dilution of the ownership structure and could, therefore, deter professional investors who have to meet specific required ownership targets.
   
• It is also important that the founders understand the deal terms of the SAFE and their implications for the future ownership structure. Two basic misunderstandings can be dangerous:
  • The Valuation Cap is NOT the floor of a future equity round. It is very well possible that the firm will have to issue shares at a valuation lower than the Valuation Cap, which will lead to comparatively larger equity dilution.
  • The Discount Rate is NOT the minimum price increase for the next equity round. It is well possible that the firm will have to raise capital at a lower price, which, again, will lead to comparatively larger dilution.
     
• As already mentioned, equity dilution is an issue. We have mentioned this point already. What is special in the case of the SAFE is the fact that the real dilution effect will only become visible during the first priced financing round. Put differently, only the FUTURE valuation will show the real dilution implications! Because dilution is somewhat "theoretical" during multiple SAFE rounds, founders risk overlooking this important aspect. This can have dramatic implications for the future ownership structure (and the firm's ability to raise professional money). Let's look at this aspect with a simple example.

Example:

Suppose a firm has 2 million shares of common stock outstanding right before a liquidity event. In the past, it has financed the business with the following 3 SAFE notes:

• • • SAFE note 1: $ 100'000 with a Valuation Cap of $ 0.50 million (no discount)
    • SAFE note 2: $ 150'000 with a Valuation Cap of $ 0.75 million (no discount)
    • SAFE note 3: $ 500'000 with a Valuation Cap of $1.00 million (no discount)

Now the firm issues 1 million shares of preferred stock at a price of $ 2 each. What will be the ultimate ownership structure after the transaction?

The following table summarizes the resulting ownership structure. For example, SAFE note 1 with a Valuation Cap of 0.5 million will convert at a conversion price of $ 0.25 into 400'000 shares of preferred stock. SAFE note 2 will also convert into 400'000 shares of preferred stock whereas SAFE note 3 will convert into 1 million shares. Together with the 1 million shares of preferred stock that will be issued to the new investors, the firm will therefore have a total of 4.8 million shares outstanding on a fully diluted basis.

The table shows the dilutive effect of the low Valuation Caps in the early financing rounds. For example, SAFE note 1 contributes 3.6% of the raised capital (= 0.1/2.75) but claims an ultimate ownership stake of 8.33%. And SAFE note 3 will get the same ultimate ownership as the preferred, despite the fact that the invested capital is only 25% of that of the preferred (0.5 million vs. 2 million). The implication of all of this is that the founders will end up with approximately 42% of the ownership. Without a Valuation Cap on the SAFEs, the founders would still control more than 60%.

• What generally aggravates the issue of equity dilution is the fact that SAFE (and Preferred) conversion is usually calculated based on the Pre-Money Valuation of the firm, that is, the value of the equity right before the injection of the additional capital. And then it is assumed that the value per share is the same for each class of stock. These two conventions (pre-money valuation and identical stock prices) artificially inflate the dilution at the expense of the current owners! 
  
  
• The latter issue (identical valuations of preferred and common stock) is discussed extensively in the course section that deals with the valuation of the different financing alternatives. Since a convertible preferred never pays less than a share of common stock, but often pays more (namely when liquidation preference is triggered), it MUST be that a share of preferred stock has a higher value than a share of common stock. Assuming identical values implies that preferred stocks are generally issued with an underpricing, which is paid by the common stockholders (the founders).