To SAFE or Not to SAFE?

VCs debate quite a bit about whether they like The YC SAFE or not. (Spoiler: Most do not…) We’ve done a lot of investments on SAFEs as well as on notes and in equity rounds, so I thought I’d outline pretty openly the pros and the cons of raising money on a SAFE.

First off, what is a SAFE?  

A SAFE is a convertible security that was developed and evangelized by YCombinator.  (500 Startups also has a convertible security called the KISS).  The convertible security concept, in itself, is an interesting innovation.  In essence, the convertible security is a placeholder for equity without the cost of both time and money doing an equity deal.  For a more detailed primer on convertible securities and the differences between those and convertible notes and equity, read my post here. (A lot of people, especially investors, confuse convertible notes and convertible securities but they are actually quite different! One is debt and the other is a placeholder for equity)

PROs for using a SAFE:

• Your legal costs will be zero or low because it’s a template
• There is no minimum threshold to raise before a deal goes through; investors simply sign and wire
• Investors receive equity when an equity round happens; if a company goes through a liquidity event before an equity conversion happens, you’ll convert to equity and receive your proportional share
• The new SAFE is a post-money SAFE, which is a BIG deal

The last bullet deserves a conversation in itself.

The post-money SAFE is easier math to calculate than the old pre-money SAFE

Previously, there was a lot of confusion before about how much equity an investor really owned.  The old SAFE was a pre-money SAFE — meaning your equity ownership was affected by how much money was raised on other SAFEs.  When companies raised lots of money at different caps on the pre-money SAFE, the math got to be pretty confusing for many people — both founders and investors.  No one really understood how much equity they owned. I also saw a lot of math mistakes in various deals that we were in that converted these SAFEs to equity. Investors were upset because they thought they owned a certain percentage of a company but then actually didn’t.  Founders didn’t understand how much of their company they had company they had sold.  This is why there are so many articles about how SAFEs are not SAFE.  The biggest pushback against the SAFE is in response to the old pre-money SAFE not the new post-money SAFE — namely, that no one knows how much equity they own.

With the new post-money SAFE, it’s quite easy for everyone to figure out how much equity has been sold.

Photo credit: Giphy

How to compute your ownership with the new post-money SAFE

Let’s say that we invest $30k on a post-money SAFE with a $3m.  We own $30k (how much we invested) / $3m (the post-money valuation) = 1% of the company.  That’s it.  When we convert this SAFE in the first equity round, we will own 1% of the company.  It doesn’t matter who else is investing and at what price or anything.

This is a lot easier for people — both investors and founders — to understand.

Now let’s say the company raises another tranche of money on a post-money SAFE with $5m cap.  Let’s say we put in $50k now.  We own with this tranche: $50k / $5m = 1% of the company.

Now when both of these SAFEs convert, they will convert at the same time.  So we now own 1% + 1% = 2% of the company upon conversion.

One update and caveat (6/7/2019): Thank you to Seth Bannon of Fifty.vc — “The new post-money SAFEs get diluted by any options pool created for the equity round (the old SAFEs did not) so an investor’s actual ownership will likely be ~10% less than this example.”

Continuing on with the other PROs…

SAFEs enable small investments

For smaller investors (such as ourselves), there’s a cost to doing a deal (mostly legal).  So, with a SAFE, this makes our costs virtually nothing.  This means that with a SAFE, as a founder, you can bring in small investment checks here and there a lot more easily, and you don’t even need a lead.

The reality is that most companies will not be able to raise a seed round with an institutional lead, but there are many more startups that will go on to do incredibly well and should be able to be backed.  I like that SAFEs democratize the startup ecosystem and make funding more accessible beyond the 100 or so seed funds that write large checks. 

What are the CONs?

These are the biggest CONs that I hear about the SAFE:

• People don’t know how much of a company they own (addressed above)
• Investors modify the SAFE
• QSBS tax exemption doesn’t apply to SAFEs
• SAFE holders don’t receive dividends

Another pushback that I often hear about the SAFE is that a lot of investors try to modify it to create weird new SAFEs.  I encourage investors to please please please not do that.  Templatizing docs, in general, is a good thing — it reduces time and legal fees to do a deal, and if you want modifications, please use a side letter.  The SAFE is meant to remain a lawyer-free template.  Templates keep the expenses down for smaller investors who cannot afford high legal fees.  Reviewing a side letter is a lot easier / faster / cheaper than reviewing a modified SAFE.

From our experience, the biggest downside as a very early investor is that QSBS tax exemption doesn’t apply to SAFEs. This is a much longer blog post, but the QSBS tax exemption was enacted in the US to encourage early stage investment.  If you hold private company stock for more than 5 years and there are other criteria met by that startup, any gains from a sale of that stock after the 5 years is tax exempt. This is amazing!  However, if you are a SAFE holder for 2 years and then you convert to equity and then the company sells 4 years later, you do not reap those benefits even though you made the investment 6 years ago.

One last corner case of being a SAFE holder is that even though you will convert to equity, if a company doesn’t raise more money nor has a liquidity event and then starts printing money and issuing dividends to shareholders, you as a SAFE holder do not get those dividends. This is a possible situation (though rare) – have never come across it myself personally.

SAFEs avoid dilution

There’s one last interesting tidbit about SAFEs – I couldn’t decide whether this is a pro or a con. I’m seeing money raised on SAFEs at the pre-seed, seed, and post-seed levels.  Let’s go back to that prior example where we invested in a company twice at two different caps on a SAFE.

Now let’s say that we invested those same amounts on two separate equity rounds at the exact same prices.  The interesting thing is that when we invest in two separate equity rounds, our first check got diluted down…  But when we invested both checks on SAFEs, we did not get diluted down, because both SAFEs converted simultaneously into the first equity round.

As we see multiple tranches of seed happen more and more, investors who write checks on a SAFE will avoid some dilution than if they were to invest in the equivalent equity rounds.

And for founders, this characteristic of the post-money SAFE is a double-edged sword.  On one hand, the post-money SAFE is great because it’s easier to figure out how much of the company a founder has sold.  On the other hand, ultimately, its founders who take more dilution on this new SAFE than on the equivalent equity rounds.  However, I think if everyone is aware of how this conversion happens, then this characteristic should just get priced into the initial cap of the SAFE.

Final thoughts

All-in-all, on the net, we, as a small fund, like the SAFE, because being able to do small deals as a small fund or an angel enables more startups to get funded. I can understand why larger funds would prefer to do large equity rounds – the reality is that often it’s the smaller investors who bubble up those deals before the large funds end up funding some of them.  And empowering smaller investors is a good thing for the ecosystem, because more startups can then have a shot at the big stage.

Featured photo courtesy of Pexels