Safe Financial Instruments Guide

The SAFE instrument form of investment often appeals to the startup or early-stage business owner seeking capital.

A Simple Agreement for Future Equity (SAFE) is a financial instrument that streamlines startups’ capital raising in early funding rounds. Developed by Y Combinator, the SAFE reduces the legal and logistical complexities of early-stage investments, allowing startups to secure funding quickly without setting an immediate valuation for the company.

Our SAFE Financial Instruments Guide is intended to help entrepreneurs understand the key benefits of a SAFE, why they may want to use one, the differences between a SAFE and a Convertible Note, potential SAFE drawbacks, the types of SAFE investors, and the resources available. Let’s dig in.

Key Benefits of SAFEs for Startups

• Simplified Negotiation: Unlike traditional equity financing, which requires a specific valuation upfront, SAFEs allow startups to postpone the valuation discussion until a future financing event, such as a Series A funding round. This flexibility benefits startups in refining their product, market fit, or revenue model, as it avoids potentially undervaluing the company in its early stages.
• Cost and Time Efficiency: SAFEs’ standardized nature reduces legal expenses and time spent on negotiations, allowing startups to focus on operational growth rather than complex financing terms. This streamlined process makes SAFEs an attractive option for founders seeking fast capital.
• Deferred Equity Conversion: A SAFE doesn’t immediately grant equity or voting rights to investors. Instead, it converts to equity during a later funding event, such as an acquisition or qualified financing round. This delayed conversion allows startups to retain control until they reach a more mature funding stage.

Why Investors Use SAFEs

SAFEs are popular with angel investors, early-stage venture capital firms, and startup accelerators. Investors benefit from a SAFE’s simplicity and lower initial cost, which allows them to convert their investment into equity when the startup’s value becomes more established.

Key Differences Between SAFEs and Convertible Notes  

SAFEs and convertible notes serve as mechanisms for startups to raise early capital while deferring a formal equity issuance until a future financing round. However, their structures and terms introduce key differences that affect the company and investors in important ways. Here’s a deeper look at these distinctions with examples:

1. No Debt Obligation with SAFEs

Convertible notes are loans that convert into equity during a future financing round but still carry debt characteristics. Specifically, convertible notes accrue interest over time and have a maturity date by which the note must either convert into equity or be repaid in cash if a financing event hasn’t occurred. This creates an obligation for the startup, adding a layer of financial risk if the company cannot secure new financing or does not want to convert the debt into equity by the maturity date.

SAFE Difference: SAFEs, on the other hand, are not debt instruments. They don’t accrue interest, and they don’t have a maturity date. This means that founders don’t need to worry about interest payments or the risk of paying investors back in cash if they can’t raise additional financing. For startups, this non-debt structure reduces pressure, particularly in early stages where revenue may be limited, and allows founders to focus on growth without the risk of a financial obligation.

Example: Imagine a startup that raises $100,000 through a convertible note with a 6% annual interest rate and a two-year maturity date. If the note hasn’t been converted to equity by the end of the two years, the company will owe the original $100,000 plus interest (a total of $112,360) or must negotiate terms with the investor. With a SAFE, the startup wouldn’t face any obligation to repay the investor by a specific date, allowing the company more time to grow and raise future funding without the pressure of a maturing debt.

2. Equity Conversion Only in SAFEs

Convertible notes often include provisions that give the company or investor some flexibility. If a financing event or conversion doesn’t occur by maturity, some convertible notes allow the investor to request repayment in cash rather than conversion into equity. This option can benefit investors who want the flexibility to obtain equity or be repaid, especially if they feel the startup’s future is uncertain. However, for startups, this cash repayment obligation could strain finances.

SAFE Difference: SAFEs are structured solely to convert into equity upon a triggering event, such as a future funding round or acquisition, with no option for the investor to request cash repayment. This makes SAFEs a more startup-friendly tool because there is no possibility of a cash drain in the future. Investors who use SAFEs must be comfortable with the potential of holding equity long-term, as they forgo the flexibility of converting to cash.

Example: Suppose an investor holds a convertible note with a maturity date and the option to request repayment in cash if no financing round occurs by then. If the startup runs into difficulties and hasn’t raised additional funds, the investor might opt for a cash payout, which could seriously impact the startup’s financial stability. By contrast, if that same investor held a SAFE, they would need to wait until an equity event to gain any return on their investment without affecting the startup’s cash flow.

3. Maturity Dates in Convertible Notes

A convertible note’s maturity date sets a timeline for the startup to raise additional financing, pushing them toward a Series A or other significant funding round within a specified period. If no financing occurs by maturity, the investor can convert the note at an agreed valuation or demand repayment. For founders, a maturity date adds urgency to secure new funding, which can sometimes lead to challenging or rushed negotiations that may not be ideal for the business’s growth stage.

SAFE Difference: SAFEs eliminate the need for a maturity date, allowing startups to proceed at a pace that better aligns with their business goals without the pressure to secure financing within a specific timeframe. This flexibility is particularly beneficial for early-stage startups that may still be experimenting with their product, market, or model and must be ready to pursue a priced financing round.

Example: A startup with a convertible note approaching maturity realizes its product development is behind schedule. It may feel pressured to secure financing even if it simply accepts less favorable terms to avoid the cash repayment obligation. A startup that issued SAFEs instead wouldn’t face this deadline, allowing the founders to delay a funding round until they can secure more favorable terms.

4. Investor Risk and Return Profiles

Convertible notes and SAFEs offer investors different risk and return profiles. Convertible note investors often see their investment as carrying lower risk due to the debt-like structure and maturity date, which increases the chance of repayment if the company does not perform as expected. Convertible notes also accumulate interest, which can boost investor returns upon conversion.

SAFE Difference: SAFE investors typically accept higher risk in exchange for the potential of higher equity returns if the company succeeds. With no interest or maturity date, SAFE holders depend on the company’s success to realize value, emphasizing the startup’s growth potential more.

Example: An investor weighing the choice between a SAFE and a convertible note might choose the note if they seek a lower-risk investment with more structured terms, including a maturity date and potential interest. However, another bullish investor on the startup’s long-term growth might prefer a SAFE, valuing the opportunity for equity without added debt complexities. For instance, many investors in Y Combinator startups accept SAFEs because they are willing to take on higher risk in high-growth, early-stage companies in exchange for a potential significant equity stake.

 Key Differences Between Convertible Note and a SAFE Instrument

Potential Drawbacks of SAFE Financial Instruments

SAFEs can introduce an element of uncertainty around ownership that may affect future fundraising rounds. This uncertainty stems from the fact that the amount of equity SAFE investors ultimately receive is determined once the SAFE converts during a subsequent financing round, like a Series A. Only after that point do founders have limited visibility into how much equity they will cede to SAFE investors, and this ambiguity can present challenges in managing the company’s ownership structure effectively.

Here’s a deeper look into how this plays out and examples of potential impacts:

1. Dilution Management and Future Investor Confidence

• Impact: When founders enter new funding rounds, investors will assess the company’s capitalization table (cap table) to understand the ownership stakes of all existing and potential stakeholders. SAFEs, by design, only convert to equity at a later financing event, meaning that the number of shares allocated to SAFE holders remains uncertain until that time. For founders, this introduces unpredictability in how much ownership they will retain after the SAFE converts. It can also impact the terms of future rounds, as new investors may be cautious if they can’t assess ownership stakes.
• Example: A startup with multiple outstanding SAFEs enters a Series A round. The investors in this round may request more significant equity or impose stricter terms to account for the potential dilution from SAFE conversions. For example, if SAFE holders are expected to gain a large ownership share upon conversion, new investors might feel their investment carries greater risk, prompting them to demand a more significant equity stake in exchange for their capital.

2. Stacking Discounts and Valuation Caps

• Impact: Many SAFEs include clauses like valuation caps and discounts, which define conversion terms. When a SAFE consists of a valuation cap, it limits the effective price per share at which SAFE holders will convert, regardless of the current market valuation during the Series A round. If multiple SAFEs are issued with different caps or discounts, the conversion calculations can become complicated, potentially leading to significant dilution for the founders.
• Example: Suppose a startup raises funds through SAFEs with varying valuation caps. If the Series A round is set at a valuation higher than one or more SAFE caps, those SAFE investors will convert their investment at a much lower price than the new Series A investors. This can dramatically dilute the founders’ equity. Additionally, future investors might request even lower valuations to compensate for the uncertainty introduced by these conversions.

3. Ownership Control and Voting Rights

• Impact: Because SAFEs lack voting rights until they convert, founders initially retain greater control over decision-making. However, once the SAFEs convert, founders might find themselves with less power than anticipated if SAFE investors convert to significant ownership stakes. This dilution of control can affect strategic decisions, as new equity holders may exert influence or voting power once they hold formal shares in the company.
• Example: Imagine a founder who has issued SAFEs in several early rounds. Upon conversion, the SAFE holders collectively gain a large portion of equity, potentially leading to a situation where the founder’s majority control is diluted. In extreme cases, the founder could even lose majority control, affecting governance decisions and potentially hindering future fundraising, as investors prefer stable and well-understood ownership structures.

4. Exit Strategies and Potential Acquisitions

• Impact: If the startup plans for an acquisition or other exit event, SAFEs can introduce complexity. Buyers usually prefer to see a clear, straightforward cap table before proceeding. With unconverted SAFEs, however, the future ownership stakes are only sometimes apparent, which can delay or complicate negotiations.
• Example: A startup with outstanding SAFEs receives an acquisition offer. During due diligence, the acquiring company realizes that SAFE holders will gain substantial equity upon conversion. This introduces uncertainty in valuing the founders’ stake versus the SAFE holders’ stake, possibly impacting the overall deal structure or resulting in a lower offer.

To mitigate the effects of SAFE-related uncertainty, startups should consider several resources and best practices:

1. Setting Uniform Terms: Issuing SAFEs with consistent caps and discounts across rounds can simplify future conversions and limit potential variations in ownership stakes.
2. Using Cap Table Management Software: Tools like Carta or Pulley can help founders model different conversion scenarios, providing better insights into potential dilution.
3. Communicating with Future Investors: When preparing for a Series A or beyond, founders should openly communicate the potential impact of outstanding SAFEs on the ownership structure to set realistic expectations with new investors.
4. Uncertainty in Future Ownership: Because valuation is deferred, founders may need more certainty regarding the percentage of ownership SAFE investors will eventually receive. This unknown factor can impact future fundraising rounds, where founders need a clearer picture of their ownership structure.

SAFEs are generally unsuitable for established companies or those with a known valuation because these businesses benefit more from traditional equity financing. This type of financing provides clarity on investor ownership and often includes voting rights and other governance structures.

It’s important to understand that while SAFEs are standardized, they may not accommodate complex investment structures or specific requirements of certain business models. In cases where startups need bespoke financing terms, a SAFE may be less suitable.

Common Types of SAFE Investors

Angel Investors: Individuals who provide capital in exchange for future equity, often through SAFEs.

Early-Stage VC Firms: Due to their speed and simplicity, Venture capital firms focused on pre-seed and seed-stage funding commonly invest through SAFEs.

Startup Accelerators: Programs like Y Combinator use SAFEs to quickly fund startups in exchange for a potential equity stake once the business reaches a specified financing milestone.

Resources When Using a SAFE Financial Instrument

Y Combinator SAFE Template: Available on Y Combinator’s website, this resource provides a standardized template and guidance on customizing terms.

Legal Counsel: Startups and investors should work with legal professionals experienced in startup financing to ensure SAFE terms comply with regulatory requirements and align with the business’s long-term goals.

Educational Guides: Organizations like the National Venture Capital Association (NVCA) and startup resource hubs like Startup School offer additional information and case studies on using SAFEs effectively.

SAFEs offer a flexible way to raise early-stage capital but come with trade-offs in ownership transparency. Careful planning and communication can help startups mitigate these challenges, ensuring that the SAFE structure supports rather than complicates future fundraising and growth efforts.