SAFE Agreement: Structure, Terms & Comparison to Notes

KEY TAKEAWAYS

• SAFE (Simple Agreement for Future Equity) agreements are investment instruments created by Y Combinator that allow startups to raise capital without debt or immediate equity valuation.
• The main SAFE types are pre-money vs. post-money SAFEs, with post-money becoming the standard since 2018 for greater clarity on ownership percentages.
• SAFEs typically include key terms like valuation caps, discount rates, pro-rata rights, and MFN (Most Favored Nation) provisions.
• Unlike convertible notes, SAFEs have no maturity date, interest rate, or debt component, making them generally more founder-friendly.
• SAFEs convert to equity automatically during qualified financing rounds based on predefined terms in the agreement.

What Is a SAFE Agreement?

A SAFE (Simple Agreement for Future Equity) agreement is a standardized investment instrument used by early-stage startups to raise capital without the complexity of convertible notes or priced equity rounds. Introduced by Y Combinator in 2013, SAFE agreements have revolutionized how seed-stage companies secure funding by simplifying the legal process and reducing negotiation points.

The fundamental concept behind a SAFE is straightforward: an investor provides capital to a startup in exchange for the promise of future equity. Unlike a convertible note, a SAFE is not a debt instrument. The investor doesn't receive interest payments, and there's no maturity date by which the SAFE must convert or be repaid. Instead, the SAFE automatically converts to equity when the startup raises a priced equity round (typically a Series A).

Evolution of SAFE Agreements

Since their introduction, SAFE agreements have evolved significantly:

Original SAFEs (2013-2018): The first generation of SAFEs were "pre-money" instruments, meaning the conversion calculation happened before counting the new money coming into the company.

Post-Money SAFEs (2018-Present): In 2018, Y Combinator released the "post-money" SAFE, which has become the industry standard. This version provides greater clarity about the investor's ownership percentage, calculating conversion based on the company's value including the new investment.

Y Combinator maintains updated templates for various SAFE versions on its website, making them freely available to the startup ecosystem. These standard documents have helped reduce legal costs and negotiation time for early-stage fundraising.

How Do SAFE Agreements Work?

SAFE agreements operate on a deceptively simple premise that belies their sophisticated structure. Let's break down the core mechanics:

Basic Structure and Process

1. Investment: An investor provides capital to the startup in exchange for a SAFE.
2. Waiting Period: The SAFE remains outstanding until a "trigger event" occurs.
3. Conversion: When a qualified financing round happens (usually Series A), the SAFE automatically converts to equity according to predetermined terms.
4. Equity Issuance: The investor receives preferred shares based on either the valuation cap, discount rate, or the valuation of the new round—whichever gives them more shares.

Key Terms in a SAFE Agreement

Understanding the key terms in a SAFE is essential for both founders and investors:

Valuation Cap

The valuation cap sets a maximum company valuation for the purpose of converting the SAFE to equity, regardless of the actual valuation in the qualifying round. For example, if a SAFE has a $5 million valuation cap and the company raises a Series A at a $10 million valuation, the SAFE holder's investment converts as if the company were valued at $5 million, giving them more shares than new investors.

Discount Rate

The discount rate offers SAFE investors shares at a reduced price compared to what new investors pay in the qualifying round. Common discount rates range from 10% to 25%. For example, with a 20% discount, if new investors pay $1 per share, SAFE holders would pay $0.80 per share.

MFN (Most Favored Nation) Provision

An MFN provision allows investors to adopt the terms of any future SAFE that has better terms than their own, protecting early investors from dilution if the company later offers more favorable terms to new investors.

Pro-Rata Rights

Pro-rata rights give SAFE investors the option to participate in future funding rounds to maintain their ownership percentage, though these are less common in post-money SAFEs than they were in pre-money versions.

Conversion Scenarios

A SAFE can convert to equity through several pathways:

Qualified Financing: When the company raises a priced equity round (typically Series A), the SAFE automatically converts to shares based on its terms.

Acquisition or Merger: If the company is acquired before the SAFE converts, investors typically receive their investment back plus an agreed-upon return, or can convert to common shares at the cap valuation.

Dissolution: If the company shuts down, SAFE holders stand in line after debt holders but before common shareholders to receive any remaining assets, although typically little remains in such scenarios.

IPO: While rare for companies with outstanding SAFEs, an IPO would trigger conversion similar to a qualified financing round.

Pre-Money vs. Post-Money SAFEs

The distinction between pre-money and post-money SAFEs represents one of the most significant evolutions in SAFE agreement structure.

Understanding the Difference

Pre-Money SAFE (2013 Version):

• Conversion calculations happen before adding the new investment to the company's valuation
• The exact ownership percentage can be unclear until the triggering event
• Formula: Investor ownership = Investment amount / (Valuation cap + All outstanding SAFEs + Option pool)

Post-Money SAFE (2018 Version):

• Conversion calculations include the new investment amount in the company's valuation
• Provides clarity up front about the exact percentage ownership the investor will receive
• Formula: Investor ownership = Investment amount / Valuation cap

Example Calculation

Let's illustrate with a scenario:

A startup raises $500,000 through SAFEs with a $5 million valuation cap. Later, it raises a $2 million Series A at a $10 million pre-money valuation.

Pre-Money SAFE Calculation:

• Conversion price: $5M ÷ (fully diluted shares pre-Series A)
• Ownership is variable depending on other SAFEs and option pool increases

Post-Money SAFE Calculation:

• Ownership percentage: $500,000 ÷ $5M = 10%
• The investor knows they will own 10% of the company, regardless of other SAFEs or option pool increases

Why Post-Money SAFEs Have Become Standard

Post-money SAFEs offer several advantages that have made them the industry standard:

1. Transparency: Both parties know exactly what percentage of the company the investor is purchasing.
2. Simplicity: Calculations are straightforward and don't depend on complex capitalization table adjustments.
3. Predictability: Founders can better manage dilution when raising multiple SAFEs.
4. Investor Preference: Investors generally prefer the clarity of knowing their exact ownership stake.

However, post-money SAFEs can be more dilutive to founders than pre-money SAFEs, as each new SAFE investment dilutes the founders directly rather than being shared among all stakeholders.

SAFE Agreement vs. Convertible Note

While SAFEs and convertible notes serve similar purposes in early-stage funding, their structural differences create distinct advantages and disadvantages for both founders and investors.

Key Differences

Feature	SAFE Agreement	Convertible Note
Legal Structure	Investment contract	Debt instrument
Maturity Date	None	Typically 18-24 months
Interest	None	Usually 2-8% annually
Default Provisions	None (not debt)	Can trigger repayment
Conversion Trigger	Qualified financing	Qualified financing, maturity, or specific events
Standard Terms	Highly standardized (Y Combinator)	More variable and negotiable
Accounting	Recorded as equity	Recorded as debt on balance sheet
Complexity	Simpler	More complex

When to Use Each Instrument

SAFEs May Be Preferable When:

• The startup wants to avoid debt obligations
• Founders prefer simplicity and lower legal costs
• The fundraising timeline is uncertain
• Investors don't require interest payments

Convertible Notes May Be Preferable When:

• Investors want downside protection
• A clear timeline for the next funding round exists
• Investors seek regular interest payments
• Regulatory requirements favor debt instruments

Investor Perspective

From an investor's perspective, convertible notes offer more protection since they represent actual debt that can be called at maturity. However, SAFEs typically offer cleaner terms and easier administration without interest calculations or maturity date concerns.

Founder Perspective

Founders generally prefer SAFEs because they:

• Create no debt obligation for the company
• Don't have maturity dates that could force premature equity rounds
• Eliminate interest accrual that dilutes founders
• Use standardized documents that reduce legal costs

How to Set Up a SAFE Agreement

Implementing a SAFE agreement follows a relatively standardized process, though care should be taken to understand all terms and implications.

Step-by-Step Implementation

1. Choose the Right Template:

   • Select between post-money SAFE (current standard) or pre-money SAFE
   • Y Combinator offers free templates at https://www.ycombinator.com/documents

2. Determine Key Terms:

   • Valuation cap (if any)
   • Discount rate (if any)
   • Whether to include pro-rata rights
   • Whether to include MFN provisions

3. Legal Review:

   • Have a startup attorney review the terms
   • Ensure compliance with local securities laws

4. Signature and Execution:

   • Both parties sign the agreement
   • Funds are transferred to the company

5. Cap Table Management:

   • Update your capitalization table to reflect outstanding SAFEs
   • Calculate potential dilution under various conversion scenarios

Common Pitfalls to Avoid

• Ignoring Dilution Impact: Multiple SAFEs can significantly dilute founders, especially with post-money SAFEs
• Inconsistent Terms: Offering different terms to different investors can create complications
• Regulatory Compliance: Failing to comply with securities laws can create serious legal issues
• Improper Documentation: Not properly documenting SAFEs on cap tables and financial statements
• Board Approval: Neglecting to get proper board approval for issuing SAFEs

Best Practices

1. Model Conversion Scenarios: Use cap table software to model how SAFEs will convert under different valuations
2. Consider Aggregate Dilution: Be mindful of the combined effect of multiple SAFEs
3. Standardize Terms: Try to keep terms consistent across investors in the same funding round
4. Keep Detailed Records: Maintain comprehensive documentation of all outstanding SAFEs
5. Disclose to Future Investors: Be transparent with future investors about outstanding SAFEs

SAFE Agreements for Different Situations

While the standard SAFE agreement works well for most situations, Y Combinator and others have developed variations for specific scenarios.

International SAFEs

Many countries have adapted the SAFE concept to their local legal frameworks:

• UK SAFEs: Adjusted for UK company law and tax considerations
• Canadian SAFEs: Modified to comply with Canadian securities regulations
• Australian SAFEs: Adapted for Australian corporate and tax structures

Alternative Trigger Events

Standard SAFEs convert on equity financing, but some include additional trigger events:

• Revenue-Based SAFEs: Convert when the company reaches specific revenue thresholds
• Milestone-Based SAFEs: Convert upon achieving predetermined business milestones
• Time-Based SAFEs: Include provisions for conversion after a specified time period

Special Purpose SAFEs

• Friends and Family SAFEs: Simplified versions for non-professional investors
• Strategic Partner SAFEs: Include special provisions for strategic investors
• Accelerator SAFEs: Customized for accelerator program investments

Side Letter Provisions

Sometimes SAFEs are accompanied by side letters that include additional provisions:

• Information Rights: Granting investors access to company financial information
• Board Observer Rights: Allowing investors to observe board meetings
• Special Voting Rights: Giving investors specific voting rights on certain matters
• Custom Liquidation Preferences: Modifying the standard liquidation terms

Common Questions About SAFE Agreements

Are SAFEs Better Than Convertible Notes?

SAFEs are generally more founder-friendly because they lack maturity dates and interest rates. However, convertible notes offer investors more protection since they're debt instruments. The "better" option depends on your perspective and specific situation.

How Do Valuation Caps Work in Practice?

A valuation cap sets the maximum valuation at which a SAFE converts, regardless of the actual valuation in the qualifying round. For example, with a $5M cap and a $10M priced round, the SAFE investor effectively gets a 50% discount on their share price compared to new investors.

Can SAFEs Have Multiple Conversion Features?

Yes, SAFEs commonly include both valuation caps and discount rates. When conversion happens, investors receive shares based on whichever mechanism gives them more equity (but not both).

What Happens If a Startup With SAFEs Gets Acquired?

In an acquisition before conversion, SAFE investors typically have options:

1. Receive their investment amount back plus a return (1-2x)
2. Convert to equity at the valuation cap and receive proceeds as a shareholder The specific terms are outlined in the SAFE's "Change of Control" provisions.

Are SAFEs Legally Binding?

Yes, SAFEs are legally binding contracts. Though simpler than many investment documents, they create enforceable rights for both parties.

How Are SAFEs Taxed?

For U.S. investors, SAFEs are generally not taxable events when purchased. Taxation occurs when they convert to equity or when the company is acquired. However, tax treatment varies by jurisdiction, and investors should consult tax professionals.

Can SAFEs Be Transferred or Sold?

Most standard SAFEs are not transferable without company consent. This restriction helps companies maintain control over their cap table and investor relationships.

SAFE Agreement: Structure, Terms & Comparison to Notes

The SAFE agreement has fundamentally changed early-stage startup funding since its introduction by Y Combinator in 2013. Its evolution from the pre-money to post-money format shows how the ecosystem continues to refine investment structures to balance founder and investor needs.

The key advantages of SAFEs—simplicity, standardization, and the absence of debt obligations—have made them popular with founders. Meanwhile, the clarity of post-money SAFEs has increased their appeal to investors who want transparency about their potential ownership stake.

When comparing SAFEs to convertible notes, the choice depends on specific priorities. SAFEs offer simplicity and remove debt obligations, while convertible notes provide more investor protection and defined timelines.

For founders considering raising funds using SAFEs, understanding the implications of valuation caps, discount rates, and how multiple SAFEs interact is essential for managing dilution effectively. With proper planning and legal guidance, SAFEs can provide an efficient path to securing early capital without the complexities of a full equity round.

As the startup ecosystem continues to evolve, so too will funding instruments like the SAFE. Staying informed about best practices and emerging variations will help both founders and investors navigate the ever-changing landscape of early-stage funding.