The Founder's Essential Guide to SAFE Agreements: From Basics to Advanced Strategies
Your Complete Guide to Startup Fundraising
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In 2013, Y Combinator introduced a new fundraising instrument that would revolutionize how startups raise early money: the SAFE (Simple Agreement for Future Equity). Today, this five-page document has become the standard way for startups to raise their first rounds of funding. Let's explore why SAFEs have become so popular and how they actually work.
What Is a SAFE?
At its core, a SAFE is a promise between a startup and an investor. The investor provides money now, and in return, the startup promises to give the investor shares in the future when certain events occur, typically when the company raises a priced round of funding. Think of it like a rain check for equity – you're getting a promise today for shares tomorrow.
Why SAFEs Changed the Game
Before SAFEs, startups primarily used convertible notes for early fundraising. While convertible notes served their purpose, they came with two significant complications:
They were debt instruments that accrued interest
They had maturity dates when the debt needed to be repaid
SAFEs eliminated these complications. They're not debt, they don't accrue interest, and they don't have maturity dates. This simplification has made fundraising faster, cheaper, and more founder-friendly.
It’s also widely adopted by nearly all YC startups and has become the go-to tool for early-stage fundraising. Check it out for yourself 👇
The Anatomy of a SAFE
A SAFE document consists of five key sections, each serving a specific purpose:
1. Event Handling
This section explains what happens in three scenarios:
When the company raises a priced round (equity financing)
When the company gets sold (liquidity event)
When the company shuts down (dissolution)
2. Definitions
This section defines all technical terms used in the document. It's like a glossary that ensures everyone understands the terminology the same way.
3. Company Representations
The company makes certain promises to the investor, such as being properly formed and having the authority to issue the SAFE.
4. Investor Representations
The investor makes promises too, such as being an accredited investor and understanding the risks involved.
5. Legal Details
Standard legal language that makes the agreement binding and enforceable.
How SAFEs Convert: A Practical Example
Let's walk through a real-world example of how SAFEs work. Imagine a startup that has raised money from two SAFE investors:
Investor A: $200,000 investment with a $4M post-money valuation cap
Investor B: $800,000 investment with an $8M post-money valuation cap
When the company raises its Series A, here's what happens:
Step 1: SAFE Conversion
Investor A ownership = $200,000 / $4M = 5%
Investor B ownership = $800,000 / $8M = 10% Total SAFE ownership = 15%This means the founders have effectively sold 15% of their company through these SAFEs, even though no shares have changed hands yet.
Step 2: Share Calculation
If the founders originally had 1,000,000 shares, the SAFE investors would receive:
Investor A shares = (1,000,000 × 5%) / (85%) = 58,824 shares
Investor B shares = (1,000,000 × 10%) / (85%) = 117,647 sharesPre-Money vs. Post-Money SAFEs
In 2019, Y Combinator updated their SAFE format to use post-money valuations instead of pre-money valuations. This change made it easier for founders to understand exactly how much of their company they were selling.
Pre-Money SAFEs
With pre-money SAFEs, the valuation cap was applied before including the SAFE investment, making it harder to calculate final ownership percentages.
Post-Money SAFEs
With post-money SAFEs, the valuation cap includes the SAFE investment, making ownership calculations straightforward. In our example above, we used post-money SAFEs, which is why we could directly calculate the ownership percentages.
Key Benefits of Using SAFEs
1. Speed and Simplicity
SAFEs can be closed quickly because there are only two main terms to negotiate:
Investment amount
Valuation cap
2. Cost-Effective
You don't need expensive lawyers to close a SAFE. The standard document is available for free on Y Combinator's website.
3. Founder Control
SAFEs don't give investors:
Board seats
Voting rights
Information rights This means founders maintain control of their company during the early stages.
4. Flexibility
SAFEs convert automatically when you raise a priced round, but you're not obligated to raise a round by any specific date.
Common Variations of SAFEs
While the standard SAFE with a valuation cap is most common, there are other variations:
1. Discount-Only SAFEs
Instead of a valuation cap, these offer a percentage discount on the price of the next round.
2. Most Favored Nation (MFN) SAFEs
These allow investors to adopt the terms of any better SAFEs that the company issues later.
3. Uncapped SAFEs
These have no valuation cap and convert at the price of the next round (rare and not recommended for founders).
Best Practices for Using SAFEs
1. Track Your Dilution
Keep careful track of how much of your company you're selling through SAFEs. Remember that the percentages add up, and you'll need to leave enough equity for future rounds.
2. Use Standard Documents
Stick to the standard Y Combinator SAFE documents whenever possible. They're well understood by the startup ecosystem and designed to be fair to both parties.
3. Understand Your Terms
Make sure you understand exactly what ownership percentage each SAFE represents. With post-money SAFEs, this is straightforward: investment amount divided by valuation cap equals ownership percentage.
4. Plan for Conversion
Remember that SAFEs will convert in your next priced round. Factor this into your negotiations with future investors.
Conclusion
SAFEs have transformed early-stage startup fundraising by making it simpler, faster, and more founder-friendly. Understanding how they work is crucial for any founder planning to raise money. While they might seem complex at first, their standardization and clear structure make them a powerful tool for getting your startup funded.
The key is to remember that while SAFes make fundraising easier, they still represent a serious commitment to give up future equity in your company. Use them wisely, keep track of your commitments, and make sure you understand exactly how much of your company you're promising to future investors.
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