SAFE (Simple Agreement for Future Equity)

A SAFE, Simple Agreement for Future Equity, is an investment instrument developed by Y Combinator in 2013, providing rights to future equity in exchange for a current capital contribution. A SAFE converts to preferred stock in an equity financing, typically at a price set by a valuation cap or a discount. A change of control, IPO or dissolution instead triggers a payout right. SAFEs are widely used in place of convertible notes at the pre-seed and seed stages, because of their simpler structure and absence of debt features (no interest, no maturity date).

SAFE vs. convertible note

Key distinctions between SAFE and convertible note: (1) SAFE is not debt, no maturity date, no interest accrual, no repayment obligation; (2) convertible note is debt, has maturity date (typically 18-24 months), accrues interest, must be repaid or converted at maturity; (3) SAFE accounting treatment, depends on the instrument's terms and is not always equity; (4) convertible note treatment, debt liability until conversion. For founders, SAFEs are typically more favorable: no maturity pressure, no interest accumulation, simpler legal structure. For investors, convertible notes provide more protection: maturity creates leverage, interest provides return on delay.

Conversion mechanics

SAFEs convert to preferred stock upon an equity financing, which the YC form defines as a bona fide capital-raising sale of preferred stock at a fixed valuation, with no minimum size. On a liquidity event (change of control, direct listing or IPO), the holder instead receives the greater of its purchase amount or the amount payable on the common stock it would hold at the price set by the SAFE's terms. On a dissolution, the holder is entitled to its purchase amount, junior to creditors and ahead of common stockholders. Conversion typically uses: (a) valuation cap, maximum conversion price (cap price); (b) discount, discount to the qualified financing price (typically 10-20%); (c) better-of, investor receives the more favorable of cap price or discount price. Y Combinator's current forms use a cap or a discount but not both, and the MFN form uses neither. A SAFE with both is a negotiated variation.

Pre-money vs. post-money SAFE

The two principal SAFE templates: (1) pre-money SAFE, original 2013 template; valuation cap is pre-money valuation; SAFE holders' ownership dilutes when subsequent SAFEs are added; (2) post-money SAFE, Y Combinator's 2018 update; valuation cap is post-money (calculated after all outstanding SAFEs convert); SAFE holders' ownership is fixed and does not dilute from subsequent SAFEs. The post-money SAFE is Y Combinator's current template. It gives investors more certainty about ownership, and the two templates produce different cap tables at conversion.

Standard SAFE terms

Y Combinator currently publishes three post-money SAFE forms: (1) valuation cap, no discount, conversion at the lower of the cap price or the financing price; (2) discount, no cap, a fixed discount to the financing price (e.g., 20%); (3) uncapped MFN, no cap or discount, with the right to adopt more favorable terms of later convertible securities, including other SAFEs and convertible notes. A pro rata side letter is published separately. A cap-and-discount SAFE is a negotiated variation of these forms.

SAFE pitfalls

Common SAFE issues: (1) cap table complexity, multiple SAFEs with different caps, discounts, and conversion mechanics create complexity at conversion; (2) founder dilution surprise, founders sometimes underestimate dilution from outstanding SAFEs at conversion; (3) valuation cap mechanics, when the priced round values the company above the cap, SAFE holders convert at the lower cap price, which increases founder dilution; (4) side letter complexity, additional terms (information rights, pro rata, MFN) added through side letters; (5) founder antidilution, typically not a feature of standard SAFEs but can be negotiated; (6) tax treatment, whether a SAFE is treated as stock for tax purposes is unsettled, which affects when any §1202 holding period begins.

Tax considerations

Tax treatment of SAFEs is uncertain in some respects: (1) investor tax basis, typically the investment amount becomes basis in converted shares; (2) §83(b) election, §83 applies to property transferred in connection with the performance of services, so it generally has no role for an investor who buys a SAFE for cash; (3) §1202 QSBS holding period, may begin at conversion rather than issuance, depending on whether the SAFE is treated as stock. (4) character on conversion, generally non-taxable like a contribution to capital.