Venture capitalists looking to invest in early-stage tech startups might come across a promising venture with no company stock to offer.
But without the funds for transaction costs related to fundraising, what can be done?
There is an agreement designed just for this type of situation—a Simple Agreement for Future Equity (SAFE). A SAFE note helps bridge gaps between investors and startups when traditional investment methods are unavailable.
To learn more about other terms commonly used in venture capital, check out our complete VC Glossary.
A SAFE note (or Simple Agreement for Future Equity) is a financing instrument that can be used to raise money without formally setting an initial company valuation. This type of convertible security allows investors to pay now, and receive shares in the startup at a later date when the business has grown its value sufficiently.
SAFEs are often referred to as convertible securities because it involves converting money into equity at a later date. SAFEs are ideal because they give founders crucial capital while bypassing painstaking formal financial valuations that often accompany equity investment rounds.
Y Combinator revolutionized the way startups fund their projects, introducing SAFEs in 2013.
Unlike a normal financing round, these allowed investors to get involved before pricing has been established – creating an agreement that’s “pre-money,” meaning ownership percentages are only solidified when everyone converts their shares during subsequent rounds of funding. This development was an innovative response to entrepreneurs who wanted faster and simpler ways for raising funds quickly.
Y Combinator recognized the investor hesitancy surrounding pre-money SAFE investments, as they bring with them an element of uncertainty. To provide more assurance and clarity in 2018, Y Combinator launched post-money SAFEs – a form of investment that allows investors to better understand their stake in the company after conversion into shares is complete.
Read more: YC Safe Financing Documents
The term pre-money is the value of a business not including external funding or the latest round of funding. It is how much a startup might be worth before it begins to receive any investments into the company. It is a hypothetical valuation.
Post-money is how much the company is worth after terms are agreed upon and the company receives the money.
Pre-Money Valuation + Investment = Post Money Valuation
A pre-money SAFE note is an agreement for future equity that allows investors to give money to a startup in exchange for shares at a later date. This type of investment can be helpful because it lets startups get the money they need without needing to figure out the company’s value first.
The downside is that investors don’t know how much their shares will be worth until after they invest. Their equity depends on the valuation and the calculation of all the other SAFEs the founders agreed upon.
If pre-money is how much the company is worth before investments, then post-money is how much the company is worth after it receives the money and investments.
A post-money SAFE note gives the investor a better idea of how much ownership percentage they will eventually have. Investors often favor a post-money SAFE note because it clearly outlines the exact ownership percentage they are receiving in exchange for their investment.
This type of SAFE is different from pre-money versions as it includes all shares issued when converted, giving investors an accurate representation of how much equity they will receive with each conversion.
Using the pre-money example above with the same investor.
Not all SAFEs are created equal, and there are some differences you’ll want to be aware of.
With pre-money SAFE notes, investors don’t know the exact equity stake they will receive in the company until after their investment is made, making them more vulnerable to dilution.
With post-money SAFE notes, investors are guaranteed a specific equity stake in the company that is established before their investment. Post-money SAFEs also provide more transparency on the valuation of the company, which can help both parties agree faster and more accurately.
Understanding the distinction between a pre-money and post-money SAFE notes requires knowledge of “Valuation Caps.” A valuation cap is the maximum value the price at which a SAFE will convert to stock ownership in the future.
It is the top valuation an investor can convert a SAFE into equity: a pre-agreed upon amount that serves to “cap” the conversion price once shares are issued.
If the company’s value rises sharply, the investor’s investment will be diluted without the cap. For these reason, savvy investors will usually press for a cap.
When looking at the next round of funding, investors must understand how to best play the game by picking either a cap or discount. A cap sets an upper limit for investment value and discounts provide investors with incentives through percentage offs – but it’s important to know that these can’t be used concurrently. Calculate carefully which one will deliver bigger financial rewards in this instance.
Pre-money and post-money SAFEs differ in how they handle pro-rata rights. Generally speaking, pre-money agreements come with pro-rata baked into the deal by default, meaning existing investors can maintain their initial ownership percentage each round of financing after the original conversion – creating some confusion for those who thought differently.
On the other hand, agreed-upon terms within a post-money SAFE will be specific to that particular agreement: it could include or exclude these key investor protections as necessary.
As investor expectations around SAFEs differ, post-money versions may include an optional side letter granting investors pro-rata rights to the round in which a SAFE converts. This way, both sides get greater assurance and clarity in how funds will be shared out when conversions occur.
Whether or not these provisions are included is up to the founders involved – so everyone needs to have a clear understanding of what can potentially be on offer.
You may also want to brush up on your limited partnership agreement knowledge.
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Ultimately, the decision between pre-money or post-money SAFEs comes down to which best suits your company’s specific needs.
Pre-money SAFEs are simpler to structure, making them a better choice for earlier-stage companies that don’t have exact valuations yet. Pre-money SAFEs can be beneficial for a business if they are seeking to raise capital quickly and with less negotiation.
Post-money SAFEs provide investors with more clarity around their equity stake. They provide investors with more security in knowing exactly how much equity they will receive in return for their investment.
Again, each type of SAFE agreement works differently depending on the needs and goals of the company and investor. Post-money SAFEs may be better suited for businesses that want to avoid dilution or need more control over their equity structure, while pre-money SAFEs are preferable if a quick raise is needed with less negotiation.
Pre-money and post-money SAFEs are two different types of financing agreements that companies can use to raise money. Each type has its advantages and disadvantages, so it’s important to choose the right one for your business. The business stage of your company may help determine which SAFE is best to use.
Reading bonus: What is a LP (Limited Partnership)?
An operating agreement is a legal document used by companies to define their organizational structure, roles and duties of owners and other key parties involved in the business, and methods for handling all transactions that occur within the company.
Stock options in startups work as a form of equity payment that allows an employee to purchase a certain number of shares of company stock at a specified price.
An over-allotment option allows companies to issue extra shares of their stocks beyond those that they initially planned or announced when they go public (or offer other securities). It’s also known as a “greenshoe option”.
Participating preferred stock is a type of preferred stock that gives the holder the option to receive dividends equal to or greater than the customarily defined rate at which preferred dividends will be paid to preferred shareholders.
