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.
What is a SAFE?
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.
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History of SAFE notes
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
Pre-Money vs Post-Money
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
What is a pre-money SAFE?
A pre-money SAFE 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.
Example of a pre-money SAFE:
- An investor gives $500,000 to a startup as part of a pre-money SAFE. The startup gives out other SAFEs as it raises money from other investors.
- The investor does not receive any shares for his $500,000 but is understood will be granted shares valued at $500,000 when the startup raises its Series A.
- The investor does not know at the time he invests how much of the company he owns. Only after the conversion of the SAFES into shares will the investors learn of their ownership stake and this won’t happen until the company has another fundraising event, typically Series A.
- At the beginning of the Series A, the investor’s SAFE converts into shares. This is done by dividing the pre-money valuation cap by the company capitalization (not including SAFES and any convertible notes).
- The pre-money value of the company is agreed upon at $10 million. This means the investor who put in $500,000 now owns 5% of the company ($500,000/$10,000,000). Then again, this stake may be diluted by new investors coming on board in the Series A.
What is a post-money SAFE?
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 gives the investor a better idea of how much ownership percentage they will eventually have. Investors often favor a post-money SAFE 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.
Example of a post-money SAFE
Using the pre-money example above with the same investor.
- An investor gives $500,000 to a startup as part of a post-money SAFE, with a $10,000,000 post-valuation cap. This cap is the pre-determined top price at which a SAFE will convert to stock ownership in the future. No matter the number of SAFE investors that come on board, the investor who gave $550k has ensured a predetermined 5% ownership stake in the company.
- There are no immediate shares granted with this $500,000. The same as pre-money SAFE, no shares are granted at the time of the investment.
- Before the Series A financing begins, the investor’s SAFE is converted into shares equaling a 5% ownership stake in the company. Other SAFEs are converted, too, but they do not dilute the investor’s ownership stake.
- However, there is dilution taking place once the new Series A investors come in. Everyone’s shares are diluted to give the new investors their new shares.
What are the main differences between pre-money SAFE and post-money SAFE?
Not all SAFEs are created equal, and there are some differences you’ll want to be aware of.
- Degree of certainty and control for investors
With pre-money SAFEs, 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 SAFEs, 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.
- Valuation Caps
Understanding the distinction between a pre-money and post-money SAFE 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.
- Discount rate
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.
- Pro rata rights
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.
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Which type of SAFE is right for my startup?
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.