SAFEs and Priced Equity Rounds

Fundraising can pose a challenge to building a startup, especially for early-stage founders, who often face the challenge of securing capital while navigating complex terms and valuation uncertainties. To address these challenges, Y Combinator introduced the Simple Agreement for Future Equity (SAFE), a convertible instrument designed to offer flexibility and simplicity in raising funds. In this article, we explore SAFEs as a popular funding option for startups and compare them with the more traditional Priced Equity Rounds. We delve into the key features, advantages, and considerations of both funding instruments, helping founders make informed decisions based on their company’s valuation stage and growth strategy.

The YCombinator Solution

Simple Agreement for Future Equity (SAFE) as the name implies, is a simple and straightforward agreement whereby the investor provides funding in exchange for a promise from the company to give shares to the investor at a future date when money is raised, usually at the next priced round. The instrument is converted to preferred shares based on the amount the company raises during the next priced round.

It is a type of convertible instrument - an investment that allows founders to get funding from investors while postponing company valuation to a later date when the instrument is converted to equity. SAFEs are quite popular among startups because of their simplicity and flexibility. Some of the other advantages of SAFE asides from postponing the negotiations of the company’s valuation till a later date is that the terms of the agreement are not cumbersome and as such allow for faster completion of the transaction.

To understand what SAFEs are, it is important to know that they are not debts. Compared to convertible notes and other debt forms, SAFEs do not have a maturity date when the fund must be paid back. Investors have to wait till the next priced round (equity-based investment round in which there is a defined pre-money valuation) or any other event stated in the SAFE that triggers conversion such as liquidation, IPO (initial public offer) or acquisition. In the event of liquidation or acquisition before the next priced round, the SAFE is converted to common stock and sold as part of the acquisition. Also, unlike debt, there is no accrued interest rate applied.

A SAFE instrument has 3 major variations - a SAFE with a valuation cap, a discount rate or a Most Favoured Nation (MFN) clause. The constituent present in the agreement determines what type of SAFE it is.

1. Valuation cap only - the capitalization sets a limit to the amount the investor will convert its investment against therefore determining the price for the preferred shares in the next priced round regardless of the valuation of the company at that time.
2. Discount rate only - a discount is offered on the purchase price of the shares in the next priced round, allowing the investor to convert to more equity per investment amount than other investors coming in at that priced round.
3. MFN Clause - the clause gives the SAFE holder the right to choose to convert at the most favourable terms offered. Where the terms offered to the investor(s) in the next priced round are more favourable, the SAFE holder is at liberty to choose between the SAFE terms or terms offered to the new investors.

Let’s Briefly Talk About Priced Equity Rounds

In the simplest terms, priced equity round is an equity-based investment round in which there is a defined pre-money valuation. It is a type of investment where founders sell equity, usually preferred stock/shares, in exchange for funding after the company’s valuation is negotiated and determined.

Unlike SAFEs, more time is required to negotiate the terms of investment. The company valuation is determined and founders know exactly how much of the company they are selling. Furthermore, the sale of preferred stock/shares in exchange for investment means that the investor is given priority over other convertible instrument holders during payouts or liquidation events. In a priced round, the founders also relinquish some control rights such as voting and anti-dilution rights to the investor.

Our Thoughts

Deciding which type of funding instrument to opt for primarily depends on the valuation data available to the founders. Generally, SAFEs offer more time and flexibility for valuation metrics to be developed as the company grows. However, if founders are satisfied with their valuation number, they may opt for priced rounds.

The number of equity founders is willing to give away must be considered. In a priced round, the term sheets are detailed and clear about the amount of equity being sold and the consequent dilution effect. In SAFEs, founders are sometimes not sure of this until the valuation is done and the share price is determined at the future financing date. This may prove extremely dilutive and bad for founder ownership if more SAFEs than required have been issued.