How Do SAFEs Work and Get Converted?

Fundraising for a start-up is quite a challenging task. You have a business that requires finance to grow, but giving up equity in the business is something that you do not wish to do at this early stage. That’s where SAFEs or Simple Agreements for Future Equity come into the picture. Now here’s the question - how do SAFEs work and get converted?  

Compared to the traditional funding models such as equity priced rounds, SAFEs are more manageable and faster to close. That’s the reason they have gained tremendous popularity among early-stage start-ups and angel investors. In this guide, we will be explaining how SAFEs operate, how they get converted, and the things that you should consider when fundraising using SAFEs. Let’s dive in!

How Does a SAFE Work?

SAFE stands for simple agreement for future equity. It is an agreement between the investor and the startup. While raising money through SAFE, there is a transfer of funds from the investor to the company. In return, they receive future equity each time the company gets more funds or goes through an acquisition. 

How do SAFEs help a startup? Well, unlike a conventional loan, they do not attract an interest or require the borrower to pay back the amount borrowed. Moreover, unlike a priced equity round, you don’t start with a set valuation. These reasons make SAFEs cheap, versatile and favourable to the founders when fundraising. 

For entrepreneurs, SAFEs are an option that allows them to avoid negotiations with investors in most cases. Nevertheless, the absence of immediate valuation of the note makes it difficult to determine its value within the company until a conversion event happens.

Discounts and Valuation Caps

SAFEs contain features such as discounts and valuation caps. Here’s what they mean:

• Discount: This enables SAFE investors to purchase the shares at a better price compared to that of later investors. For example, if a SAFE has a 20% discount and the next funding round values shares at $1, then the SAFE investor buys them for $0.80. Discounts help to compensate for the additional risk of investing in the startup before it generates more evidence of success and its prospects’ commitment. If a startup achieves product-market fit before receiving a priced round, SAFE investors with a discount will have lower cost basis, which would give them the greatest possible return on investment.
  
  
• Valuation Cap: This places a cap on the price when the SAFE converts into shares. If a SAFE has a $5M cap and the next round values the company at $10M, then the SAFE investor is much better off when converting his investment to equity. Valuation caps are put in place to ensure that the early investors get a certain percentage on the equity before conversion, even though the company has a higher value at the time of conversion. It also ensures that fairness between the founder and the investor is achieved in terms of equity sharing.
  
  

These features lock in early investors and provide incentives to them in terms of high risk reward ratio. Lack of specific information on the valuation cap may lead the investors to get less percentage of the company in case the value of the business soars high at the time of conversion of SAFE. It also helps startups to attract investors while keeping more options open in terms of funding.

‍Conversion Events

There are some conversion events through which SAFEs get converted. Here are the most common ones:

1. Priced Equity Round: When the startup sells money in a conventional round, SAFEs get converted into stocks. This type of conversion is the most common one being associated with growth to a certain level which enables the company to fix a value for its shares and attract institutional shareholders.
   
   
2. Acquisition or IPO: If the company is acquired or goes public prior to a priced round, SAFE investors may receive cash or stock as per the terms of the SAFE. This outlook is positive for investors if the acquisition or the IPO occurs at a high value, but in instances where the firm exits at a lower value, SAFE investors may receive less than they expected to.
   
   
3. Liquidation: If the company ceases operation before a conversion event occurs, SAFE investors are considered similar to equity shareholders with no ownership claims to the company. Nevertheless, certain SAFE have dissolution rights which state that the investors are repaid partly especially when there are any remaining balances before shutting down.

Knowledge of conversion events is essential for both founders as well as the investors. They define circumstances and dynamics of when SAFE investments get converted to equity and subsequent influence on ownership and financials. All these possibilities should be explained to the investors before venturing into the business, so that the appropriate expectations are set right from the outset.

Pre-Money and Post-Money SAFEs

SAFEs exist in two variations known as pre-money and post-money.

Pre-money SAFEs: Pre-money SAFEs served as the initial type of this financing instrument. The conversion happens according to pre-funding valuation after the investors contribute new funds. The term was unclear regarding the percentage of company ownership SAFE investors would attain. The valuation set before new investments made it hard for investors to accurately assess ownership shares in pre-money SAFEs. The founders faced difficulties due to SAFE dilution that occasionally created unforeseen equity allocation problems.

Post-money SAFEs: The updated version of SAFEs comes in the form of post-money SAFEs. The post-money SAFE calculates investor equity by determining shares after converting all SAFEs into equity. They provide clear ownership predictions to investors and founders which helps them plan their funding strategies. Post-money SAFEs provide better clarity about equity distribution which makes them a popular choice between investors and startups.

A startup should decide between pre-money or post-money SAFE based on its future investment approach and expectations from potential investors. Modern fundraising operations mainly shift towards post-money SAFEs because these instruments provide both simplicity of use and clear documentation.

Pros and Cons of Fundraising with SAFEs

Pros:

✅ Fast and Simple: No lengthy negotiations. Just sign and go. This made SAFEs a perfect fit for early-stage startups.

✅ Founder-Friendly: There is no rush to set a valuation to quickly. Founders retain the freedom to make decisions about the valuation of the startup at some point in the future.

✅ Investor Incentives: Discounts and valuation caps are offered to the investors. This allows investment in the early stages when the startups require capital the most.

Cons:

❌ Uncertain Ownership: Some founders are often unaware of how much equity they are putting up in the business. This can create issues in the next rounds of funding.

❌ Investor Risks: There is a potential that a startup company will never complete a priced round of funding, which means the SAFEs will never convert either.

❌ Potential Dilution: Excessive use of SAFEs complicates a company’s funding rounds later on. Founders should always ensure that their cap table does not get out of control through dilution. 

How to Raise with a SAFE

Fundraising with a SAFE is quite simple:

1. Set Terms: Agree on your valuation cap or the discount and any other set terms. Take into consideration the market factors as well as investors expectations.
2. Find Investors: Go to angel investors, venture capitalists or friends with deep pockets. Introduce your startup and present the rationale for investing through SAFE.
3. Follow a Standard SAFE Template: There is a common SAFE agreement provided by Y Combinator. It also guarantees compliance to the set standard in the industry.
4. Sign and Collect Funds: Once investors agree to invest, they sign SAFE and transfer the money. Always keep these agreements documented.
5. Track Your SAFEs: Know who invested and terms for that investment. Documenting is very important for fundraising. 
6. Convert When Ready: When a conversion event occurs, SAFEs are converted to equity. Avoid risks and potential pitfalls by planning ahead. 

Conclusion

SAFEs is a well-known method for startups to get early-stage financing. SAFEs have been around for several years. They’re fast, flexible, and investor-friendly. However, with these comes strings attached, like the issue of ownership and dilution of shares at conversion. Making the complexities of SAFEs and their conversion understandable is necessary to assist both sides of the deal. 

We hope now you have got the answer to the aforementioned question - how do SAFEs work and get converted. If you want to learn more about investment and financing of startups, join the Venture Fundamentals course by Angel School. It is a great guide to learning the various aspects of financing startups. Happy fundraising!