Raising capital is often the first major administrative hurdle a founder faces. You have the vision and the drive, but you likely lack the funds to execute at speed. When you approach investors at the earliest stages, putting a specific price tag or valuation on your company is difficult.
This is where the SAFE comes in.
SAFE stands for Simple Agreement for Future Equity. It was introduced by Y Combinator to standardize early-stage fundraising. It is a contract between a company and an investor. The investor provides capital to the company immediately. In exchange, the company promises to give the investor stock at a future date, usually when a specific triggering event occurs.
It is important to understand that a SAFE is not debt. It is also not equity. It is a warrant to purchase equity later.
How the Conversion Works
#The SAFE does not give the investor immediate ownership in your business. Instead, it converts into equity during a future priced round. This is usually when you raise a Series A or a significant Seed round where a lead investor sets a firm valuation for the company.
To protect the early investor for taking a risk on you when you were just an idea, SAFEs typically include specific terms:
- Valuation Cap: This sets a maximum price that the investor’s money will convert at. If your company value skyrockets, the early investor gets to convert their money at this lower, capped price. This grants them more shares for their money.
- Discount Rate: This gives the investor a percentage off the price per share paid by new investors in the future round.
- MFN (Most Favored Nation): A clause that allows the investor to adopt more favorable terms if you issue a better SAFE to a subsequent investor.
SAFE vs. Convertible Notes
#Before the SAFE became popular, the Convertible Note was the standard for seed financing. They are similar but have distinct legal differences.
A Convertible Note is debt. It is a loan. Because it is a loan, it has a maturity date and it accrues interest. If you do not raise a future round of funding by the maturity date, the investor can technically demand repayment.
A SAFE is not a loan. It does not accrue interest. It does not have a maturity date. This removes the ticking clock pressure from the founder. It allows you to focus on building the product rather than worrying about a looming repayment deadline.
The Risks of Dilution
#Because SAFEs are easy to issue, founders often treat them like casual agreements. This is dangerous.
Every SAFE you sign is a promise of future equity. If you stack multiple SAFEs on top of each other with different valuation caps, you may be surprised by how much of the company you no longer own once the conversion happens. This is often called the dilution waterfall.
Founders need to ask themselves hard questions before signing. Do you understand the math of the conversion? Have you modeled out what your cap table looks like if you raise your next round at a valuation lower than your cap? Understanding these mechanics is vital to retaining control of your business.