Easy Guide to SAFEs and How they Work

Simple Agreement for Future Equity (“SAFE”) is an investment vehicle commonly used to raise funding by startups. 

They are simple, but just like with anything relating to equity, there’s a lot of confusion and misunderstanding about how they work and there are aspects that aren’t so “simple”.

The Basics

What Is It?

SAFEs are a legal document that is nothing more than the name suggests, a promise. It’s a legal promise that in exchange for an investment, the founder will give the investor an equity stake in the company at a later date.

Is It Equity or Debt?

SAFEs are not debt or equity.

They are neither.

They’re a binding legal agreement for equity that will be given to the investor in the future

What's the Alternative?

The alternative to a SAFE is a Convertible Note (or Convertible Debt). 

Unlike a SAFE, a Convertible Note is debt, until it converts into equity. 

Why Is It Not Debt or Equity?

Why It's Not Equity

A SAFE does not grant or issue stock to the investor. It is simply a promise for future equity. 

This is done because the value is not yet determined and without a value, you don't know how much equity to exchange.

Since no equity is formally exchanged, it's not equity. It's a hybrid investment vehicle.

Why It’s not Debt

SAFEs came out as an alternative to a Convertible Note. Since Convertible Notes are just a fancy loan, founders and investors had to negotiate the interest rate and maturity date of the loan. 

These negotiations were slowing things down. So a SAFE was developed to remove these variables. 

I can’t tell you whether that was intentional or not, but the result was no longer a loan. 

Why Do SAFEs Exist?

Delay Valuation
SAFEs allow investors and founders to DELAY the question of valuation. Startups are very difficult to value in the early stages. 

Investors and founders can rarely agree on a valuation so SAFEs (and convertible notes) are used as a bridging instrument to allow the company more time to grow while making sure it has the capital it needs.

The “Valuation Cap”

If you’ve had the pleasure of reading or maybe even using a SAFE you’ll know that it does have a Valuation Cap. And it’s often thought of as the Value of the business. In fact, both SAFEs and Convertible Notes often have Valuation Caps.

Investor Can Get a Lower Price than Valuation Cap

However, Valuation Caps are NOT the value of the company. Valuation Caps are the implied MAXIMUM that the investor and founder agree is the value of the company. 

At the conversion, the Convertible Note  will convert into equity (given the investor chooses that option) at a valuation no higher than the valuation cap, but if the value comes in below that (what is referred to as a “down round”) then the original investment plus accrued interest will convert at the lower value. 

This way the investor ensures the best price.

When Does a SAFE convert to equity?

The Trigger

The legal documents usually include a conversion trigger. In nearly every case, conversion is triggered by another financing round.

Financing Round

The financing round usually has to be “qualified financing” round. That just means that it has to be big enough. Sometimes that’s defined by a specific dollar value and sometimes it’s a very vague definition. 

At that point the valuation is a combination of multiple investors opinions.