What is safe in investing?

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SAFE notes (often just referred to as SAFEs) are an increasingly popular financing instrument for early-stage investors.

If you’re investing at the early-stage, it would behoove you to understand what SAFEs are and why VCs like to use them—which is why we wrote this guide.

We’ll cover how SAFEs work, their benefits and drawbacks for founders and investors, and how they compare to other investment instruments.

SAFE stands for “Simple Agreement for Future Equity.” Y Combinator introduced this concept in 2013 after finding that founders of pre-revenue companies were having difficulty raising their first round of funding. The standard form of SAFE was updated in 2018 as the Post-Money SAFE: our discussion here will be focused on this form of SAFE.

SAFEs are a form of convertible financing. To understand how SAFEs work, it helps to first understand what convertible notes are. Convertible notes are short-term debt instruments that convert to equity upon a predetermined event—typically a priced financing round or a liquidation event like an acquisition.

SAFEs are different from convertible notes in that they’re not a debt instrument. They’re also usually simpler and shorter. This simplicity is where much of the benefit lies for founders and investors.

What makes a SAFE “simple”?

Unlike convertible notes, SAFEs do not have:

When investors invest in a SAFE, the SAFE’s terms give them the right to convert their SAFE into equity at the company’s next equity financing round or liquidation event.

The terms of the conversion are usually determined by either a valuation cap or a discount rate:

In general, there are four types of SAFEs:

What happens if a liquidation event, such as an acquisition, happens before the priced equity round?

Here, the SAFE holder generally has two options:

SAFEs offer investors:

SAFEs offer founders:

These benefits make SAFEs an increasingly popular instrument, though they do carry potential drawbacks.

When investing via SAFEs, investors should be aware that:

Likewise, founders using SAFEs to fund their companies should be aware that:

The dilution possible when issuing SAFEs is a major factor that founders and investors should understand. A simple back-of-the-envelope way to gauge the levels of dilution is by using the following formula:

For example, if you raise $500k from a SAFE with a $5M post-money valuation cap, you are effectively selling 10% of your company. If you raise $1M with the same post-money valuation cap, that number rises to 20%.

The lesson for founders: Pay close attention to how much future equity you’re be giving up when raising money with SAFEs.

SAFEs were introduced as a direct alternative to convertible notes. While there’s no “one size fits all” answer to which investment instrument is best, here are questions to help you decide which approach makes the most sense for you:

For founders:

For investors:

Although SAFEs were designed to be standardized, some companies will use SAFEs that don’t follow the standard form.

The standard form of a Y-Combinator Post-Money SAFE includes the following message at the top:

“This SAFE is one of the forms available at http://ycombinator.com/documents and the Company and the Investor agree that neither one has modified the form, except to fill in blanks and bracketed terms.”

If the SAFE you’re using does not include this language, it’s worth an extra careful review to understand how it differs from the standard form.

A SAFE is an agreement to provide you a future equity stake based on the amount you invested if—and only if—a triggering event occurs, such as an additional round of financing or the sale of the company.

This first stage of funding is known as the seed round.

At this phase, most companies don’t have paying customers, market traction, profits, or even revenue, making it difficult (if not impossible) to come up with a reasonable valuation of the company.

That’s where tools like SAFEs and convertible notes become useful. Both of these financing methods give startups a way to raise money without receiving a valuation or giving up equity in the early stages.

SAFE stands for “simple agreement for future equity.” It’s a type of convertible security that early-stage startups can use to fund their business without valuing the company or giving up equity initially.

In this agreement, the investor gives the company cash in exchange for the right to buy equity in the company after a triggering liquidity event, which is typically the next funding round.

Calloway Cook, owner of supplements company Illuminate Labs, recommends that startups “use SAFE notes in fundraising when they have a website or app but no real users,” as the lack of users will make it difficult to get a reasonable valuation.

The agreement usually includes a valuation cap or discount rate that rewards SAFE investors for taking the risk of financing a new company.

For example, let’s say an investor enters into a SAFE agreement with a startup. They invest $5m in exchange for the right to purchase future shares during the company’s first priced round of financing.

They can purchase shares at a valuation cap of $15m or with a discount rate of 20%. The discount rate only kicks in if the company receives a valuation at or below the valuation cap.

One year later, the company launches a Series A round with a valuation of $25m. Since the company has begun a priced round, the investor can now convert their shares. Instead of purchasing at the company’s $25m valuation, they get to convert at the $15m maximum valuation.

If the said company was valued at $15m, the investor would get a 20% discount, and buy in at a $12m valuation.

As SAFE agreements don’t have maturity dates, the investor can’t convert their agreement until the next round of financing happens, whether it takes four months or four years. Conversely, if the business fails, the startup isn’t on the hook for repayment as SAFEs are not debt instruments.

However, under a typical SAFE agreement, investors are entitled to repayment before the company’s founders receive distributions. If there’s not enough money to pay investors back fully, then SAFE investors will receive a portion of the remaining liquidity relative to their ownership in the company.

Silicon Valley incubator Y Combinator created the SAFE in 2013 as a simpler alternative to the convertible note, which also lets startup companies raise money before they’re ready for a valuation.

The convertible note is a loan that carries interest and eventually converts into preferred stock after a maturity date or triggering event. Similar to the SAFE agreement, convertible notes let early-stage startups raise money without giving up equity straight away or having a valuation.

Since it’s a loan, it means the startup company is taking on debt. However, instead of paying back the loan amount in cash, the company has the option to pay off the convertible debt with equity after a conversion event.

Convertible notes can be written to include a variety of conversion terms, any of which can trigger the conversion of the loan amount into equity, such as:

The agreement also includes a maturity date, which is when the loan converts if none of the triggering events have happened yet.

Oberon Copeland, founder and CEO of economics publication VeryInformed, advises setting maturity dates “between 12 and 24 months out, so the company has time to achieve milestones before giving away equity.”

Convertible notes also include valuation cap and discount rate agreements. After the trigger event or maturity date, the company needs to pay back the loan.

Typically, the debt is repaid through equity, using the conversion method that gives the investor the lowest price. However, companies also have the option to repay the loan using cash if they want to avoid diluting their equity.

The term “equity” refers to ownership in a business that is typically expressed as a percentage of the total shares of a company.

A SAFE is a legal contract that gives the investor the right to purchase equity in the future. In contrast, a convertible note is a debt instrument (or loan) that converts into equity at a later date.

SAFEs and convertible notes are alternatives to equity financing, and they let seed-stage and pre-seed startups raise money without requiring a valuation. They also postpone the selling of equity, which means that startup founders retain their decision-making power until later on.

SAFEs and convertible notes are not equity at the time of agreement. However, after a trigger event occurs or the maturity date for a convertible note passes, the investor can convert the agreement into equity using the valuation cap or discount rate terms — whichever gives note holders the lower price.

SAFE agreements and convertible notes are both useful seed funding tools. However, because of the way each agreement is structured, they have different pros and cons.

SAFEs and convertible notes are both intended to turn into equity at a later date, and they’re appropriate for young startups that need to raise money but aren’t ready for a valuation.

To get a better idea of which type of investment is right for you, consider the key differences between the two:

In general, SAFE agreements are considered more founder-friendly because they provide more flexibility and don’t carry interest. Convertible notes tend to be more investor-friendly because the maturity date imposes more restrictions on founders.

Ultimately, the right option comes down to the method that works for you and your potential investors. If you can’t find investors willing to use SAFEs, then it makes more sense to issue convertible notes.