Key takeaway:
Safes aren’t equity (yet) or debt. Instead, they will turn into equity if the company does a priced round. If the company exits, the safe investor gets back their money along with a return. If the company fails, the safe investor is paid back the investment in full or in part, assuming there are funds left.
Beware, though: safes isolate investors from dilution until they convert, thus pushing all dilution upon founders. And if none of the above events take place, investors will never get back their money or stock.
Over the past five years or so, safe agreements (or, simply, safes) have soared in popularity, to the extent that they have become synonymous with pre-seed or seed financing rounds. If a founder says, “We’re raising a pre-seed round of $X,” it’s generally understood that the instrument being used is the safe.
However, with all that added limelight, safes remain the least understood type of investment method, compared to more traditional financing tools such as the convertible note and the priced round.
The goal of this post is to explain the safe, simply.
Here we go.
What is a safe agreement?
In simple terms, a safe (which stands for Simple Agreement for Future Equity – smart, huh?) is an investment document. It’s a method for investors to invest funds in a startup. That’s pretty obvious to everyone. However, what sometimes is not so obvious is what a safe is not.
So, is a safe equity?
Nope, a safe is not equity. When an investor invests money in your startup through a safe, you don’t give them equity (or stock) in your company – at least, not yet.
If you have a priced round in the future, that’s when you’ll give the investors stock in return for their investment. Until (and unless) that time comes, the investor is not a stockholder.
Just a quick recap: a priced round (also known as a preferred stock round, or VC round, or equity financing) is a financing event where you agree that your company has a certain valuation and issue stock to investors based on that valuation.
I see. So, is a safe debt?
Nope, it’s not debt either. It’s not a loan. When you take a loan, you have to return it by a certain date (the maturity date), and interest builds up on the loan amount. Safes don’t work that way.
Now, mind you, there is a situation where you do have to return the money you got through a safe. For example, if you’re closing shop, you have to return the money you received from your investors back to them (or, if you don’t have that much money left, you’ll have to split it among the investors in proportion to their investments).
Understood. So, tell me, what is a safe?
You know, what I like to say is that a safe is a promise, expressed in the form of a signed contract.
Oftentimes, someone who’s hearing about the safe for the first time may ask me, frustrated (especially if it’s an investor), “So, wait a minute, I invest all this money and I don’t get stock? So, what do I get?”
My response is normally along the lines of, “You might not be getting a stock certificate, but you’re still getting a paper – a signed sheet of paper – that you can “cash in” for stock or a return on your investment if certain events happen.”
It might sound tongue-in-cheek, but it’s true.
A safe is a promise.
When you sign a safe and take money, you’re making a promise to the investor that if certain events happen, they’ll get stock or a return on their investment. Let’s talk about this next.
How do safes work?
The simplest way to understand how safes work is to think in terms of cause-and-effect. The causes, in this case, are the triggering events – or, simply, “events.”
The investment money just sits in the startup’s bank account until one of these events happens. If and once an event happens (the cause), something happens to that money (the effect).
Let’s talk about each of the three main events.
CAUSE: You raise a priced round
EFFECT: Safes turn into preferred stock
The first event is called the equity financing – or the priced round. If the startup raises money and issues preferred stock at a certain valuation, then you have an equity financing on your hands.
If this happens, the investor’s money automatically turns (or converts) into preferred stock. Figuratively speaking, the investor hands back the “signed paper promise” and gets a stock certificate in return – that same stock certificate the investor was hammering me about in our first meeting.
How much stock, you ask? We’ll get to that in the next section.
CAUSE: You exit
EFFECT: Your safe investor gets back what they put in or a return, whichever is larger
The second event is called the liquidity event, which is a fancy name for what you normal people (i.e., non-lawyers) call an “exit.” Essentially, this kicks in when:
- You sell your company, such as when you sell more than 50% of your company’s ownership or you sell all or almost all of your company’s assets, or
- You go public.
If this happens, your investor gets back the money they invested or a return on their investment, whichever is larger. This return is calculated by looking at how much money the investor would receive when you exit if their investment had turned (or converted) into stock.
How much stock, you ask again? Yes, yes, I hear you – we’ll get to that in the next section.
CAUSE: You shut down
EFFECT: Your safe investor gets back what they put in or a part of that, if money is tight
The third event is the dissolution event, which is the least appealing. That’s when you have to close your business because things didn’t work out.
If this happens, your investor gets back the money they invested. Or, if the money you have at hand isn’t enough to pay out all the investors (including safe investors and preferred stock investors), then you’ll have to pay out each in proportion to their investment.
What if none of these events happen?
That’s an excellent question. If none of the above happens, then the safe just floats in a state of limbo, stuck in the twilight zone… forever (technically). The investor will get nothing, the startup does not have to pay the investor anything, and that would be entirely legal.
Safe vs. Convertible Note: What are their differences and similarities?
First off, an important disclaimer: the safe is not a note. A “note” is a document that evidences indebtedness – commonly known as an “IOU” (pronounced just like what it means: “I owe you”). When one person gives a note to another, it means that they owe that person money.
A safe is not a note.
And so, there is no such thing as a “Safe note.”
Which brings us to the first fundamental difference between a safe and a convertible note.
A convertible note is debt; a safe is not.
Just like any other debt, a convertible note has a maturity date (the date by which it must be returned) and an interest rate. Therefore, a convertible note must either convert into stock or be returned just like a loan – by the maturity date, with interest accrued atop the principal amount.
With a safe, there is no maturity date or interest rate. And while a safe is subject to return (in case of an exit or the startup shutting down), that obligation to return the investment is different from the obligation to repay a loan. You must repay a loan by a certain date. With the safe, there is no such date; as mentioned, if none of the “cause” events happen, the safe investment will technically never have to be returned to the investor.
A convertible note is issued under a note purchase agreement. There is no equivalent document for the safe.
When a company raises a convertible note round, there are two key documents at play:
- the note purchase agreement, which lays out the terms under which the company is issuing notes (such as the size of the round and the representations that the company and investor make); and
- the convertible promissory note, which is the actual “IOU” – the document that the company gives to the investor laying out the principal amount, the interest rate, the maturity date, and the conversion terms.
In the case of a safe round, you simply have one document per investor: the safe agreement. The safe agreement includes the amount invested, the conversion terms, as well as the representations made by the company and the investor. There’s no need for a separate, “parent” document.
There is no “standard convertible note template document,” whereas there is a “standard safe template.”
While convertible note documents are fairly similar from company to company, there is no one standard that all (or most) companies follow. Therefore, whenever an investor receives a convertible note package, their counsel will normally review the documents from top to bottom.
In the case of the safe, however, the YC safe is essentially the OG safe. Don’t quote me on this, but a (vast?) majority of the safes issued are still based on the YC safe. Further, it’s immediately evident if the startup has used the YC safe, since it has the following language at the top:
This Safe is one of the forms available at Y Combinator and the Company and the Investor agree that neither one has modified the form, except to fill in blanks and bracketed terms.
As a result, parties are able to quickly sign off on a safe because there’s no need to review the document line by line.
That being said, there are similarities between these two types of investments.
The conversion terminology is the same.
Both convertible notes and safes may have a discount, post-money or pre-money valuation vap, and/or an MFN clause as the terms based on which the invested amount converts. More about these concepts in the next section.
Both types of rounds should be approved by the Board.
At the end of the day, both convertible notes and safes are securities, and, just like in the case of other securities, the company’s Board must approve their issuance.
Many companies overlook this crucial step when issuing safes. Fortunately, this normally isn’t a big issue and the issuance of the safes can be “ratified” – or approved after the fact.
Both investment types require securities filings.
As a rule of thumb, for a company to issue securities, it must either register them with the Securities Exchange Commission (the federal agency that oversees securities) or rely on an exemption.
Relying on an exemption normally requires making a filing with the SEC – commonly, a Reg D filing. Since both convertible notes and safes are securities, doing a round with either type triggers a filing requirement within 15 days of the first investment coming in. This, too, is an action which is often overlooked. Fortunately, if the company has missed the filing deadline, it can normally still file and enjoy the benefit of the exemption without penalties.
What are the types of safes?
Both convertible notes and safes may have a discount, post-money or pre-money valuation vap, and/or an MFN clause as the terms based on which the invested amount converts. More about these concepts in the next section.
Based on the conversion terms
As mentioned, in case of a priced round, the safe converts. Now, how the safe converts depends in part on what type of safe is being used. In this sense, these are main types of conversion terms:
• Discount
When the company does a priced round, the safe investment turns into preferred stock at a discount of what other, non-safe investors are paying for that same preferred stock. I bring an example in the next section.
• Valuation cap
A valuation cap puts a cap – or ceiling – on the valuation of the company. If the company does a priced round at a significantly higher valuation, then the safe investment turns into preferred stock at the lower valuation cap. For an example, check out the next section.
• Most Favored Nation
An MFN safe does not normally provide a discount or valuation cap. Instead, it says that this safe investor gets the best terms available to any safe investor that invests after they do. Again, example below.
• Mixed terms
While YC puts out three versions of the safe – with a discount, with a valuation cap, and MFN – it’s possible to mix and match these terms. For example, a few years ago it was common to see a safe with both a discount and a valuation cap. Alternatively, it’s not uncommon to have a safe with a valuation cap and an MFN clause – in which case, you guessed it, if the company gives out a future safe at a better (lower) valuation cap, the first investor can have this lower valuation cap apply to its own safe as well.
• Uncapped safe
This version of the safe is probably the simplest (and most uncommon)t. It has no preferential term for the safe investor – whether in the form of a discount, valuation cap, or MFN clause. Instead, this safe investment converts into preferred stock at the same price per share which the “new-money” investors (defined below) will be paying.
Based on type of valuation cap: post-money or pre-money
Safes can be categorized according to whether their valuation cap is pre-money or post-money.
As mentioned in the next section, the first YC safes had a pre-money valuation cap. In 2018, this was replaced with the post-money valuation cap, with the intended purpose of making it much easier for founders to figure out how much they’ll be diluted, at a maximum, by a given safe and for investors to figure out how much equity, at a minimum, they will be getting if the safe converts.
While the essence of both documents are the same, the pre-money and post-money valuation cap safes differ in how the price per share for safe investors are calculated. The post-money safe results in a more investor-friendly outcome, since the converting safes dilute the then-existing stockholders (normally, the founders) but are not themselves diluted by other converting safes.
Based on the author
The safe is the brainchild of Carolynn Levy, partner at YCombinator, who invented the pre-money safe back in the winter of 2013. It’s not every day that a new type of legal document is born, especially one which then goes on to redefine a whole industry. The safe is such an example, and kudos to Carolynn for giving this to the world.
This makes the YC pre-money safe the OG safe. Since then, YC has come up with the post-money safe, and other companies have come up with their versions of the safe, including Clerky and, recently, Carta. All the ones I’ve seen, however, seem to have simply reshuffled the content of the YC safe and/or used different words for the same concepts, yet the principles have stayed the same.
Could you provide some examples of how a safe converts in a priced round?
Of course! Let’s go through each type of safe in turn. Here’s the priced round scenario we’re working with:
- $15M post-money valuation
- $3M in new money (this is jargon for money that is being invested in that round, as opposed to money that has been invested previously, such as through safes)
- The company’s fully diluted capitalization pre-closing and before the safes convert is 10,000,000 shares of common stock. The option pool has been fully issued.
- After the closing, the company should have a 10% unallocated option pool.
I’ve left out the actual calculations since these can get notoriously complicated. Instead, I’m providing examples to present the logic on how each type of safe converts. Assume each safe is for $100K and that the safes are not converting all together – each example should be viewed separately.
Example 1: Safe with a 20% discount
This safe investor will get the same preferred stock for a discounted price. In the present scenario, the new-money investors will be paying $1.0375 per share of preferred stock. At a 20% discount, this safe investor gets the same share of preferred stock for $0.83, and the $100K investment converts into 120,481 shares of preferred stock.
Example 2: Safe with a $10M post-money valuation cap
To determine the price per share this safe investor will pay, we divide the post-money valuation cap by the fully diluted company capitalization of the company after the safe converts but before the priced round closes and before the option pool increases.
We need to do some reverse engineering here. With a $100K safe investment at a $10M post-money valuation, the safe investor should be getting 1% (or $100K divided by $10M) of the company before the priced round and option pool increase. To achieve this, the safe investor should receive 101,010 shares of preferred stock.
Why? Because 101,010/(10,000,000 + 101,010) = 1%.
Divide $10M by 10,101,010 (the fully diluted capitalization of the company after the safe converts – but before the priced round closes and the option pool increases), and you’ll arrive at a price per share of $0.99.
What about the new-money investors? They’ll be purchasing preferred stock at $1.0396 per share.
Example 3: Safe with a $10M post-money valuation cap and a 20% discount
In this instance, the safe investor will have her investment convert into preferred stock at the better price per share – whether it’s the price per share achieved based on the 20% discount or the $10M post-money valuation cap. Since we’ve already done the math in the previous two examples, we can apply there here as well:
- With a 20% discount (see Example 1), the safe investor achieves a price per share of $0.83.
- With a $10M post-money valuation cap (see Example 2), the safe investor achieves a price per share of $0.99
Having one’s investment turn into preferred stock at a lower price per share is preferable for the investor, since it results in more shares. So, the safe investor in this instance would rather have the 20% discount apply, for a $0.83 price per share, and she’ll receive 120,4810 shares of preferred stock for her $100K investment.
Example 4: MFN
Assume here that we have three investors, who invested in the startup as follows:
- On March 1, 2022, Investor 1 invested $100K under a safe with an MFN clause;
- On September 1, 2022, Investor 2 invested $100K under a safe with a 20% discount; and
- On February 1, 2023, Investor 3 invested $100K under a safe with a $10M post-money valuation cap.
It’s an unusual scenario, but bear with me here for the sake of the illustration. Since Investor 1’s safe has an MFN clause and he has invested before Investor 2 and Investor 3, he can have either Investor 2’s or Investor 3’s safe’s terms apply to his own safe as well.
Based on Examples 1 and 2, we see that the 20% discount safe yields a better result, and so, here as well, Investor 1 would rather have the terms of Investor 2’s safe apply to his own safe. However, take note that the price per share would be different in this scenario, since we have multiple safes converting (as opposed to the previous examples, where we had only one safe converting).
Also, keep in mind that a safe investor with an MFN clause has only one shot to “use” the MFN privilege; once this investor has another safe’s terms apply to their own safe, they cannot then again have yet another safe’s terms apply to their safe (unless the safe they chose also has an MFN clause).
Example 5: Uncapped
In an uncapped safe, the investment doesn’t get special treatment and instead converts at the same price per share at which the new-money investors are investing.
Following the current scenario, a $100K uncapped safe will convert at a price per share of $1.04, yielding 96,153 shares of preferred stock.
Alright, noted on all this info. But I have some more questions, such as…
Why do safe investors get the benefit of a discount or valuation cap?
Simply put, because of the additional risk they assume by investing in an early-stage startup. Safes are normally used before the first priced round – or in between priced rounds. These are the phases of the company’s lifecycle where the risk is higher than otherwise, and this is particularly true before the company has done its first priced round.
In order to incentivize these investors to invest, the company adds a carrot: the discount and/or the valuation cap. The goal is to balance out the investor’s additional risk.
Are there any dangers for founders involved with safes?
Well, I’m glad you asked. In fact, yes, there is one hidden danger that often goes unnoticed until it’s too late. Those who are not intimately familiar with how a safe works are particularly vulnerable to this mistake, and, so, I hope to preempt such situations by shining light on this aspect.
Safes – specifically, valuation-cap safes – can be ticking time bombs.
Sounds scary, no? Let me explain.
When an investor invests through a valuation cap safe, they’re essentially guaranteeing the minimum equity they’ll eventually get when the safe converts. If it’s a $1M investment at a $10M post-money valuation cap, then the investor can expect to get no less than approximately 10% of the equity in the company once the safe converts in a priced round (I say approximately 10% because the new-money investors of that round will dilute the safe investor).
Here’s the crux of the issue; this safe investor will be getting that roughly minimum 10% investment no matter what the company’s priced round valuation is when the safe converts – whether the company raises at a $15M valuation or a $150M valuation.
Now, imagine a scenario where the safe has not converted for years. Years have passed, and the company is finally doing its first priced round after issuing these safes… and it’s doing it at a $150M valuation. The $10M-capped safe will give the investor an approximately 10% stake in the company.
Good for the investor, don’t you think? Their $1M investment is worth approximately $15M now (or 10% of $150M).
But we’re forgetting about the D-word here.
Dilution.
With the safe investor converting so far down the line, the resulting dilution for the founders is much more than they would otherwise have to bear had the safes converted earlier.
You see, once the safe converts, the resulting equity stake is subject to normal dilution just like everybody else’s (taking into account any anti-dilution provisions). Had this safe converted at a $15M valued round, the investor would still have received their 10%, and that 10% would have started being diluted in future rounds… so that when the company eventually did the $150M priced round, the equity stake would have shrunk (that is, been diluted) to a fraction of the 10%… or roughly 1%.
By converting only at the later, higher valuation, the safe investor has been legally shielded from dilution, instead pushing the entire burden of the dilution upon the stockholders existing immediately prior to the priced round.
Using absolute numbers rather than percentages would make this danger more apparent. Without providing actual numbers, simply note that a $15M valuation company would likely have less fully diluted stock than a $150M valuation company – and, so, a 10% stake would be equal to that much more stock in the hands of the investor if it converts at the $150M valuation instead of the $15M valuation. Assuming the founders did not get additional equity grants (also known as refresher grants), the dilution hit they would have to bear is greater when the investor gets more shares of stock for the same amount of money.
Oh wow… and are there any dangers for investors involved with safes?
Yep, investors aren’t immune to the dangers of safes either. As mentioned, if none of the triggering events – or “causes” – take place, then the investor’s funds can stay with the company forever. The safe will be stuck in the twilight zone, in a state of limbo, and there will be nothing, legally, that the investor can do about the situation. While an unlikely scenario, it’s a real risk that materialized in the case of Toptal.
Should I do a safe round or a priced round?
This is a question for a startup attorney who knows your specific situation. That said, here are a few general rules of thumb to take into consideration:
| Do a safe round if… | Do a priced round if… |
|---|---|
| You won’t be closing the entire round in a short period | You’ll be receiving all your investments within a short period (say, three months or so) |
| You don’t have a lead investor | You have a lead investor – someone who will put in at least half of the target round size |
| You’d like to be through with fundraising quickly | You’re ok waiting about two months or so from term sheet to closing |
| You’d like to keep expenses to a minimum (ballpark of $5,000) | You feel comfortable picking up a large legal bill (normally upward of $50,000 for a Seed or Series A round). |
| You’re raising less than a $1M | You’re raising $1M or more |
In terms of fees, keep in mind that the company normally takes care of the lead investor’s legal fees as well, up to a certain amount. The mentioned figure reflects the aggregate amount (the company’s and investor’s legal fees).
Also, keep in mind the founder-facing danger mentioned above. If you’ve done multiple safe rounds, you’ll probably be better off doing a priced round that would convert all outstanding safes.
What are some best practices to be mindful of when using safes?
Here are some general legal tips to keep in mind when doing a safe round.
- Approve the safe round with a Board resolution in advance. This part is often overlooked by startups that don’t work with a competent attorney.
- Provide the exact same safe terms to all investors who invest in a given period. In other words, if two investors invest a week apart from each other, they should receive the exact same terms (for example, the same post-money valuation cap), unless a material and unexpected event takes place during that week.
- Similarly, if substantial time passes after you’ve raised a safe round and the company has registered meaningful progress, you can consider raising a follow-up safe round at terms more favorable for the company (for example, at a higher post-money valuation cap).
- Some investors may ask for pro rata rights, which are covered in a side letter (a topic for a future post). Have a principle based on which you’ll decide when to give such rights to an investor and when to politely decline. Normally, this is based on the amount of investment.
- Keep an eye on your safe investments and always be mindful of the resulting dilution.
Templates, resources, and some final thoughts
Over the past years, safes have become a thing of their own – a round in their own right and the implied pre-seed or seed investment document. While not entirely perfect, safes have done a great job in getting cash in the hands of ambitious founders quickly and cheaply, while making sure investors are taken care of as well.
If you’d like to learn more about safes, here are some great resources you can access:
Of course, if you’ll have any questions about this post, do feel free to reach out.
