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SAFE 101: Startup Funding

What’s the secret to meeting the complex funding needs of a startup? Truthfully, it’s flexibility. One way to find that flexibility is by using a simple agreement for future equity, or SAFE, to bridge the gap.

Let’s take a closer look at what this tool is–and how it works.

What is a SAFE?

A Simple Agreement for Future Equity, or SAFE, is a financial instrument for startup funding. It’s an alternative to traditional convertible notes that provides the investor a right to obtain equity shares at a future date.

SAFEs do not accrue interest or come with a maturity date. Instead, the terms of the agreement define a trigger event. This means that SAFEs are not debt; they’re also not exactly equity (at least not until the investment converts). 

SAFE Traditional Convertible Notes
Nature of InvestmentAn investment with the right to obtain equity in the future.Debt instrument that can be converted into equity later.
OwnershipDoes not provide immediate ownership stake.Does not provide immediate ownership stake.
Interest or DividendsNoYes
ValuationDoes not establish an initial valuation for the company.May establish an initial valuation.
ConversionConverts into equity based on a specified trigger event (e.g. future financing round). Converts into equity at a predetermined price or valuation cap.
Debt LiabilityNoneYes, Until Conversion
Investor ProtectionMay include some investor-friendly protections (depending on the language), but not standard.Typically include more extensive investor protections.
Maturity DateNonePredetermined
UsageEarly-Stage Startup FundingEarly & Later-Stage Funding

How SAFEs Work

Startups have complex funding needs. In response to the unique challenges many startups face, the popular startup accelerator and early-stage venture capital firm YCombinator, created SAFEs to bring simplicity, efficiency, and alignment to startup funding.

Essentially, a SAFE is an investment agreement. A startup and an investor negotiate the terms of a simple agreement that includes:

  • Amount of Investment
  • Valuation Cap
  • Conversion Trigger
  • Conversion Process
  • Termination

The startup receives the investment dollars and continues to pursue growth. When the trigger event occurs, the SAFE converts to equity, and the investor becomes a shareholder.

Pre-Money vs. Post-Money SAFEs

The difference between the two lies in the valuation of the company at the time of the investment and the resulting ownership stake for the investor.

Pre-Money SAFE Investments

In a pre-money SAFE, the valuation of the company is determined BEFORE the investment amount is added. At conversion, the investor’s ownership stake is determined based on this pre-money valuation. This option is typically more founder-friendly.

pre-money SAFE

Let’s look at an example:

If a startup has a pre-money valuation of $10 million and a new investor contributes $2 million through a pre-money SAFE, the post-money valuation increases to $12 million (pre-money valuation + investment). 

At conversion, the investor’s ownership stake is 16.7% ($2 million / $12 million).  The existing shareholders are diluted down to 83.3%

Now, let’s assume the company raises another $3 million under the same SAFE, bringing the total funds raised to $5 million. The post-money valuation is now $15 million. 

The original investor that invested $2 million would end up with 13.3% upon conversion, and the existing shareholders are only diluted down to 66.7% ($10 million / $15 million).

Post-Money SAFE Investments

In a post-money SAFE, the valuation of the company includes the investment amount is added. As the SAFE valuation includes the investment, the investor’s ownership stake is pre-determined. Unlike the pre-money SAFE, the investors’ pro forma ownership does not change with additional investment in the SAFE. Naturally, this option is typically more investor-friendly.

post-money SAFE

Here is an example:

If the SAFE’s post-money valuation is set at $10M and an investor contributes $2 million in a post-money SAFE, the investor’s ownership stake is determined at 20%. 

2 million / 10 million = 0.20

Similar to the prior scenario, let’s assume the company raises an additional $3 million under the same SAFE, bringing the total funds raised to $5 million.

As the post-money valuation (which includes the capital raised) is capped at $10 million, the original $2 million investor would still own 20% ($2 million / $10 million). The difference is that the existing shareholders would be diluted down to 50% 

($10 million – $2 million) – $3 million / $10 million

Which Option is Better?

Carta recently published statistics that show “Current market terms for pre-seed SAFE investments” 

It’s not surprising that post-money SAFEs are dominant (the power of Nudges and Defaults). But it’s worth noting that many companies opted to take the pre-money SAFE route, which we believe is more founder/company friendly. 

There are pros and cons to both methods. Ultimately, the details of the specific agreement provide more insight into which option is better suited for each party. When YC pioneered the SAFE note, it was originally a pre-money structure. In October 2018, they changed their default to a post-money structure. 

This change does not signal that post-money is better than pre-money. Founders should heavily consider both options and the inherent pros and cons of each in line with the terms of their specific agreement. 

Keep in mind when founders and investors colloquially say they raised a SAFE round at a $X million valuation cap – that could mean very different things depending on whether it is a pre-money SAFE or a post-money SAFE. 

Bottom line–don’t default to a post-money SAFE simply because YC does. Weigh your options with trusted advisors and make an intentional decision. 

Implications Under the Current Economic Environment

Under the current environment with rising interest rates and lower public company valuation multiples, many startups in the growth stage (series B and beyond) are using SAFEs as a bridge round. 

A startup may need capital, but if they raised a priced equity round right now, the valuation would be lower than their prior round (a down-round). SAFEs are typically used for early-stage companies where it is difficult to assess a valuation. Growth stage companies are using SAFEs to bridge themselves until they can overcome the current valuation headwinds and get to a flat or up-round. 

A post-money SAFE can be especially scary in this situation. Given the uncertainty of the current environment, many startups do not have clear visibility into how long of a bridge period they need. 

This may result in a case where the startup raises continues to raise more capital under the SAFE than initially expected. As the post-money valuation is capped, this can have a punitive impact on existing shareholders, as illustrated above. 

Here is the Take-Home Message on SAFE Funding for Founders

A SAFE (Simple Agreement for Future Equity) is an alternative to traditional convertible notes for startup funding. It grants investors the right to obtain equity shares in the future, typically at a trigger event. Unlike convertible notes, SAFEs do not accrue interest or have a maturity date. They do provide flexibility and simplicity in startup funding, but that doesn’t mean they don’t require careful thought and planning.

At Embarc Advisors, we specialize in helping startup founders plan for financial success. We can help you evaluate your funding options so that you can use SAFE funding along with other instruments to achieve your growth goals without giving up an ownership stake in your company.

Contact our team to learn more about how we can help with startup funding.

Read More: Startups Playbook for Cash Flow Sustainability

See the Difference that Embarc Advisors Can Make for Your Business

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