SAFEs (Simple Agreements for Future Equity), first created by Y Combinator in 2013 and the mechanics of which have been subsequently modified over the years, have become increasingly prevalent as a way for companies to raise funds at the earliest stages of a company’s growth or in between larger-priced rounds.

For both investors and founders, however, SAFEs can be anything but simple. From the investor standpoint, SAFEs have no maturity date and, unlike convertible notes, accrue no interest. SAFE investors do not have equity or voting rights until the event that triggers the conversion of their investment into shares (usually a priced financing round but this can also be an acquisition or IPO), and if the startup fails to ever raise a priced round, the investors could lose the entirety of their investments.

For founders, although the standardized documentation of SAFEs can reduce the time and expenses associated with fundraising compared with a priced round, any failure to fully understand the conversion terms of the SAFEs can lead to unexpected dilution. Because this dilution does not clearly manifest itself until the conversion event, the dilutive impact of SAFEs can be overlooked and exacerbated over time as more SAFEs are issued. Therefore, it is crucial that founders understand and model the potential impact before agreeing to terms.

While all SAFEs are negotiable and the terms of any individual SAFE might not comport with the standard form, there are four primary variants of SAFEs, with Y Combinator now providing forms for three of these.

Valuation Cap, No Discount: This variant may be best suited to startups with a somewhat predictable valuation cap trajectory and is intended to protect investors from the excessive dilution that would occur if the conversion were to take place at a much higher valuation. A valuation cap sets a maximum value at which the SAFE will convert into equity, thereby establishing a floor of percentage ownership.

For example, an investor agrees to invest $500,000 via a post-money SAFE with a $10 million valuation cap. The startup receives the money today, but the investor does not receive any shares until the conversion event. The actual number of shares that the investor receives upon conversion and their price are somewhat immaterial (the number depends on the company’s valuation and the number of fully diluted shares outstanding at the time of conversion). The important figure is the percentage the investor receives. In the example above, the investor receives no less than 5% ($500,000 divided by $10,000,000) of the company once all converting securities have been accounted for but not including the new money investment.

If the valuation cap were $12.5 million, the investor would receive at least 4% ($500,000 divided by $12,500,000) of the company; if the valuation cap were $8.0 million, the investor would receive at least 6.25% ($500,000 divided by $8,000,000) of the company. Although these differences might seem inconsequential today, they can morph into multimillion-dollar regrets for founders as the valuation of the company increases.

While the valuation cap for an individual SAFE is fixed and does not change once issued, if investors raise capital through SAFEs over time utilizing a tranched or staggered approach, it is important for companies to incrementally adjust the valuation cap for subsequent SAFEs. The cash raised directly adds to the company’s value, and the valuation cap should also reflect the startup’s evolving valuation as it hits product milestones, increases its customer base or achieves revenue growth.

The ownership stake that post-money SAFEs convert into is additive and not subject to dilution from other SAFEs. Assuming a transaction occurs with a post-money valuation in excess of the applicable valuation cap, the cumulative ownership stake that founders give up (at the priced round or liquidity event, but before the dilution of the new money investment) will be the sum of the percentages derived (on a SAFE-by-SAFE basis) from this formula:

SAFE Amount / Valuation Cap = Ownership Stake

It shouldn’t be assumed that the largest SAFE by dollar amount will equate to the largest ownership stake being given up in percentage terms. In the table below, the $1,200,000 SAFE results in the largest ownership stake.

In the event the company has a priced round where the pre-money valuation is lower than the SAFE valuation cap, then the SAFE converts at the lower of the two valuations and the investor is entitled to receive an even larger ownership stake in the company. For example, a priced round with a pre-money valuation of $7.0 million would mean a $400,000 SAFE with an $8.0 million cap would convert as $400,000 / $7,000,000, resulting in a 5.7% ownership stake.

As a reminder, the ownership percentage that a SAFE converts into is “post-money” vis-à-vis any SAFEs, convertible notes and other convertible securities converting in the financing but is before the dilution of the new money investment.

Discount, No Valuation Cap: This variant may be most suitable when founders and investors agree it is too early in the company’s lifecycle to accurately assess the company’s anticipated fair market value at the next financing. The discount is designed to compensate investors for the higher risk they are taking by investing at an unknown valuation.

The discount is entirely negotiable but tends to fall between 10% and 30%. Note that the form for this type of SAFE uses the term “Discount Rate” to mean 100% minus the discount, so a SAFE with a 20% discount would have a discount rate of 80% (100% minus 20%). As this nomenclature is counterintuitive and inconsistent with how investors have historically described discounts in convertible notes, it can trip up unsuspecting founders.

The dilutive effect of the discount is, however, even easier to overlook.

If new investors are paying $1.00 per share, a SAFE investor with a discount rate of 80% (a 20% discount) would receive shares at $0.80 per share. A $500,000 new money investment would result in 500,000 shares being issued. A $500,000 SAFE with a 20% discount would result in $500,000 divided by $0.80, or 625,000 shares being issued—25% more shares than the new investor received.

The key formula for calculating the ownership stake from a discount-rate SAFE, again before the dilution of the new money investment, is:

SAFE Amount / (Pre-Money Valuation x Discount Rate) = Ownership Stake

Between the valuation cap SAFE and discount SAFE, which is worse for the founders? The answer, unfortunately, will not be known until the priced round occurs. The valuation cap SAFE conversion percentages are known at the time the SAFE is signed, assuming the SAFE converts at the cap. The discount-price SAFE will convert at a discount to the pre-money valuation of the priced round.

In the example below, a $500,000 SAFE with a valuation cap of $8.0 million results in an ownership stake of 6.25%. A $500,000 SAFE with an 80% discount rate and a pre-money valuation of $10.0 million would result in the same 6.25% ownership stake.

Valuation Cap and Discount: This variant combines the primary features of each of the two types of SAFEs described above. Although a SAFE with both a valuation cap and a discount does not result in the two being applied cumulatively—sometimes referred to as “double-dipping”—enabling the investor to receive the more favorable alternative between the cap and the discount could be seen as punitive from the founders’ perspective.

$500,000 SAFE with 80% Discount Rate (20% Discount)

Here the 20% discount provides a higher ownership stake for the SAFE investor at lower pre-money valuations. After an equilibrium is reached, the valuation cap provides a higher, fixed ownership stake even as the pre-money valuation continues to climb.

This form is no longer provided by Y Combinator, and their website user guide from February 2023 notes:

“Consistently, YC’s recommendation to founders was to issue either the valuation cap flavor safe or the discount flavor. We did not encounter situations where the combo safe was the preferred choice. Accordingly, we decided it was incongruous to make [a version including both terms] available.”

Despite this, approximately 30% of SAFEs still feature both a valuation cap and discount.

Most Favored Nation (MFN), No Valuation Cap, No Discount: Providing no valuation cap or discount, this variant is infrequently utilized but gives investors the right to receive the same terms as future SAFE investors do. This version may be appropriate for investors that want to participate quickly without too much negotiation and are willing to have future SAFE investors negotiate the most beneficial terms.

Although the ease of raising money via SAFEs is compelling, their simplicity can belie their ability to unexpectedly dilute founders, and best practice is to consult with counsel before terms are agreed on.

It is unlikely that real-world examples will calculate as neatly as the ones provided, but the same immutable laws of mathematics apply to all SAFE conversions. Valuation caps should never be reduced to a simple number for the sole purpose of easing the calculation of their future conversion. It is rare, however, for discount-rate SAFEs to have a discount rate of something like 18.5%, with values in 5% increments instead being more prevalent.

Just as founders can be surprised by the unanticipated dilution of SAFEs, SAFE investors can also be surprised by the dilution of the new money investment from the priced round. A SAFE does not grant an investor an ownership stake that is fixed in perpetuity. A SAFE investor wanting to maintain a specific ownership level might consider requiring a side letter agreement that includes pro rata rights enabling the investor to participate in the priced round in which the SAFE converts.¹