This blog was originally written for our KorePartner Bian Belley at Crowdwise. View the original article here.
Since its creation in 2013, the use of the SAFE has proliferated as an early-stage financing instrument and is now used everywhere from Silicon Valley VC deals to online crowdfunding rounds. However, not all SAFEs are created equal.
The SAFEs used in VC rounds and in angel SPVs can be quite different from SAFEs on crowdfunding platforms. Even SAFEs between crowdfunding platforms (e.g. Republic vs. Wefunder) will have key differences that investors should be aware of.
In this article, we will review the basics of the SAFE and discuss key differences between crowdfunding SAFEs and traditional SAFEs.
What is a SAFE?
A Simple Agreement for Future Equity (SAFE) is a type of early-stage investment security that converts to equity at a specified conversion event in the future. It is roughly equivalent to a Convertible Note, only without a maturity date or interest rate.
History of the SAFE
The famed accelerator Y-Combinator originated the pre-money SAFE in 2013. Its use was adopted in Silicon Valley and quickly spread throughout the world. Today, SAFEs are used everywhere from Silicon Valley to online crowdfunding portals, though specific deal terms still vary.
In 2018, YC updated their boilerplate SAFE to be a “post-money” SAFE, which means that it now converts based on post-money valuation instead of pre-money valuation. Another notable update included adding in provisions that explicitly treat the SAFE as equity for purposes of taxes under IRC Section 1202.
The latest post-money YC SAFE templates can be found here; however, many SAFEs on crowdfunding portals still use the pre-money SAFE as of late 2021. Also, conversion triggers in crowdfunding SAFEs are usually different than those found in the standard YC SAFE used in accredited deals, as we will discuss below.
SAFE Deal Term Basics
The two most important deal terms associated with a SAFE are its discount rate and valuation cap.
Some examples of SAFE terms include:
- SAFE with $5 million valuation cap and a 15% discount
- Uncapped SAFE (i.e. no valuation cap) with a 25% discount
- SAFE with a $15 million valuation cap and no discount
As you can see, both the discount rate and the valuation cap will vary between each SAFE. Furthermore, both terms are optional, so a SAFE may have both, or just one or the other (rarely will a SAFE have neither).
SAFE Conversion Examples
A SAFE will convert to equity at the better of either the valuation cap or the discount rate.
Let’s say you invest in a SAFE with a $5 million valuation cap and a 20% discount. Here are some different conversion examples.
- If the startup raises a follow-on financing round at a $6 million post-money valuation:
- The valuation cap would be $5 million.
- The 20% discount would be at an effective $4.8 million valuation ($6M*0.8 = $4.8M).
- Since the discount rate ($4.8 million) is better than the valuation cap ($5 million), your SAFE would convert under the 20% discount at an effective valuation of $4.8 million.
- So if current investors in the $6 million post-money round were investing at $1 per share, SAFE investors would get a $4.8/$5*1 = $0.96 per share.
- If the startup raises a follow-on financing round at a $10 million post-money valuation:
- The 20% discount would be an effective $8 million valuation.
- Since the $5 million valuation cap on the original SAFE is a better deal for investors, the SAFE would convert at the valuation cap of $5 million.
- So if current investors in the $10 million post-money round were investing at $1 per share, SAFE investors would get a $5/$10*1 = $0.50 per share.
Discount rates will give a better conversion price if the follow-on round is similar to the prior round (up to the amount of the discount). For rounds and exits that have much steeper increases in valuation, the valuation cap will give the more favorable terms.
When do SAFEs Convert to Equity?
A SAFE converts to equity at a specified conversion event in the future. Typical conversion scenarios may include an exit (e.g. acquisition, IPO, etc.) or a future financing round, such as a Series A round after an initial Seed round.
Especially on crowdfunding portals, conversion triggers will vary from SAFE to SAFE. Investors should always read the subscription agreement for each deal in its entirety.
The three types of conversion events typically specified in a SAFE include:
- Equity Financing Event (e.g. follow-on financing round – e.g. Series A, Series B, etc.)
- Liquidity Event (e.g. if there is a merger, acquisition, IPO, or other liquidity event prior to the conversion of the SAFE, that may trigger a conversion to equity)
- Dissolution Event (e.g. the company shuts down operations)
Converting into Common vs. Preferred Equity
While the standard Y-Combinator SAFE converts to Preferred Equity, crowdfunding SAFEs — such as those used on Republic and Wefunder — will vary in terms of whether they convert to Common Stock or Preferred Stock.
Common Stock is the type of equity held by founders and employees of a company, while Preferred Stock is the type of equity typically held by investors. Among other differences, Preferred Stock typically comes with a liquidation preference (e.g. 1X, 2X, etc.), meaning Preferred shareholders will be paid back prior to Common shareholders should the company be liquidated.
Both Common and Preferred shareholders are paid after debt-holders and creditors, and that’s only if there is anything left to be paid.
SAFEs that Convert to Shadow Series Shares
Some crowdfunding SAFEs, such as the Republic Crowd Safe, may convert to “Shadow Series” shares.
This essentially means that Crowd Safe holders will receive the same class of shares (e.g. Common or Preferred), only those shares will have limited voting and information rights.
What Happens When a SAFE Company Fails?
If a startup fails, investors will be paid out based on the “dissolution event” provisions of the SAFE terms and the “liquidation priority” order.
In general, investors should not expect to receive any capital back when a company fails, since the proceeds of the failure, if any, will first be paid to debt holders.
In the standard Y-Combinator post-money SAFE terms, a SAFE is paid out:
- junior to payments of outstanding indebtedness and creditor claims,
- on par with other SAFEs and Preferred Stock, and
- senior to Common Stock.
This is typically found under the “Liquidation Priority” section of the SAFE terms.
Summary of Crowdfunding SAFE Differences
Now that we have a solid understanding of the deal terms and basics of the SAFE, we can review the most common differences between crowdfunding SAFEs and traditional SAFEs:
- Crowdfunding SAFEs may have optional conversions: in some crowdfunding SAFEs (such as Republic’s Crowd Safe), shares convert at the next equity financing round at the discretion of the issuer (i.e the startup). While most traditional SAFEs are forced to convert at the next qualified financing round, many crowdfunding SAFEs give the company the option to either convert to equity or defer conversion until a later time.
- While this may sound like a bad thing for investors at first, we’ll discuss in a future article why this can be a win-win for both the company and the investors.
- Crowdfunding SAFEs may convert to Shadow Series shares: in the Republic Crowd Safe, the SAFE may convert to shadow shares, which means the same class of shares (e.g. Common vs. Preferred) as other investors, but with limited voting and information rights.
- Crowdfunding SAFEs Investing via an SPV: When you invest in a SAFE on Wefunder, you’ll often be investing in a Special Purpose Vehicle (SPV). While this is typical for angel investors on sites like AngelList, this means you’ll actually be investing in the SPV (e.g. “Company X, a Series of Wefunder SPV LLC”), and not be directly investing in the company itself.
- Investing in an SPV may have potential tax implications (because the SPV is an LLC). Furthermore, investing in an SPV may have implications in terms of the potential future liquidity of that investment due to complications when listing SPV shares on a secondary market.
- Many Crowdfunding SAFEs are still Pre-Money: while the standard Y-Combinator SAFE was changed to convert based upon post-money valuation in 2018, many of the SAFEs used on crowdfunding sites today are still using pre-money valuation for the conversion price.
- Some Crowdfunding SAFEs may have repurchase rights: something that most VCs and angel SAFEs would never have is a “repurchase rights” or “redemptive clause”. These terms allow the company to buyback SAFE investors at the company’s discretion, which typically happens if a later-stage VC wants to “clean up” the cap table (i.e. get more control and ownership for themselves) or when the company is doing well and wants to buy out early investors. As we’ll discuss in a future article, investors should avoid SAFEs with these terms. These terms put the company’s best interests at odds with that of the investors’.
- The good news is that I have not seen any SAFEs recently with these repurchase terms (although I have seen some Common Stock offerings on some platforms with repurchase rights, so be careful!). It seems that crowdfunding portals have realized that these repurchase rights often end poorly for investors and are used by issuers who might not have their crowdfunding investors’ best interests at heart.