In December 2013, Y-Combinator announced the Safe, a Replacement for Convertible Notes via their terrific blog post written by Paul Graham. In short the “Simple agreement for future equity” (Safe) was created by Y-Combinator partner (and lawyer) Carolynn Levy is a
non-debt alternative to convertible notes. It offers advantages relative to convertible debt without some of the disadvantages.
non-debt alternative to convertible notes. It offers advantages relative to convertible debt without some of the disadvantages.
As many entrepreneurs and venture capitalists know, the convertible note has become a standard instrument for early stage, angel, and seed financing. It makes fundraising quick and easy by eliminating the need to negotiate terms required by a stock transaction; valuation being one of the biggest. Rather it is a right to buy stock when a qualified equity round happens, typically a Series A. There are however some disadvantages of a convertible note given that it is a debt instrument most notably the term and interest rate. YC’s blog post does a super job describing the issues so they are not recounted here. The YC blog also provides links to a Safe Primer that describes various versions of the Safe instrument and example scenarios of how conversion can happen in the case of follow on financing and acquisition.
The Safe instrument has three primary dimensions: the investment amount, Safe valuation cap, a discount, and an optional most favored nation clause. Unlike convertible notes, a Safe has no expiration or maturity date and terminates when the Safe holder receives stock or cash as part of an equity financing, change of control transaction, IPO or dissolution. Similar to a Convertible Note the Safe instrument converts automatically into equity when the company decides to sell preferred stock as part of a priced round such as a Series A. Conversion terminates the Safe turning the holders into preferred stockholders. Also, as convertible notes, the Safe often has a valuation cap and provides the advantage of conversion at the cap should the pre-money valuation of priced round exceed the cap in the Safe instrument.
Safe holders inherit many of the same rights, privileges, preferences and obligations as preferred stockholders such as pro rata rights, liquidation preference, and anti dilution. If the startup goes out of business and shuts down the Safe holder has a liquidation preference over common stock holders and will therefore receive any money available to distribute prior to the common holders. If the company is acquired or merges with another company the Safe holder can convert into common stock or have the Safe investment returned depending on what is most advantageous to the Safe investor. Similarly if the company goes public the Safe will convert into common stock at the Safe valuation cap.
The Safe Primer provided by YC includes an excellent set of 9 example scenarios in which a Safe instrument is used and subsequently converted or cashed out. “We have advised on several convertible notes and have had increasing interest and questions from startups about the Safe instrument,” says former venture investor Marc Theeuwes and startup advisor, “as part of a recent Safe transaction a startup and investor asked that we advise on an appropriate Safe version so we created the Safe Spreadsheet as a tool to show how all the scenarios work out.” The Safe Spreadsheet complements the 9 Y-Combinator examples detailing the calculations for each scenario. Several additional startups have asked for a copy of the spreadsheet so it is published here as an educational tool. Feel free to download the Safe Spreadsheet here: SafeSpreadsheetExamples
The 9 Y-Combinator examples and scenario parameters are summarized below:
Example 1, Equity Financing, Safe Valuation Cap, No discount = In this case the equity financing pre-money exceeds the Safe valuation cap. The Safe converts into Safe Preferred A-1 Stock at a price per share determined by the Safe cap divided by company’s fully diluted outstanding shares.
Parameters:
- Safe instrument = $100K investment, valuation cap $5M, no discount rate.
- Equity financing: $1M of Series A preferred at $10M pre valuation, 11M fully diluted shares.
- Outcome = Safe converts to Series A-1 preferred stock and doubles value.
Example 2, Equity Financing, Safe Valuation Cap, No discount = In this case the equity financing pre-money is lower than the Safe valuation cap. The Safe cap is inapplicable and the Safe instrument converts into preferred stock at a price per share determined by the equity financing pre-money valuation divided by company’s fully diluted outstanding shares.
Parameters:
- Safe instrument = $100K investment, valuation cap $4M, no discount.
- Equity financing = $600K of Series A preferred at $3M pre, 12.5M fully diluted shares.
- Outcome = Safe converts to Series A preferred stock, same value.
Example 3, Equity Financing, Safe Valuation Cap, No discount = In this case the equity financing pre-money is equal to the Safe valuation cap. Similar to Example 2, the Safe instrument converts into preferred stock at a price per share determined by the equity financing pre-money valuation divided by company’s fully diluted outstanding shares.
Parameters:
- Safe instrument = $100K investment, valuation cap $8M, no discount.
- Equity financing = $2M of Series A preferred at $8M pre, 11.5M fully diluted shares.
- Outcome = Safe converts to Series A preferred stock, same value.
Example 4, Acquisition, Safe Valuation Cap, No discount = In this case the company is acquired at a valuation that exceeds the Safe valuation cap. The Safe instrument converts to common shares.
Parameters:
- Safe = $100K investment, valuation $10M, no discount.
- Acquisition = $50M valuation, 11.5M fully diluted shares.
- Outcome = Safe holder can choose to receive the $100K investment or convert to common with a value of almost $500K. Since the convert value is 5X more than the initial investment, the Safe investor will elect to convert to common.
Example 5, Acquisition, Safe Valuation Cap, No discount = In this scenario the company is acquired at a valuation below the Safe valuation cap. The Safe does not covert and the investor cashes out of the Safe.
Parameters:
- Safe = $100K investment, valuation cap is $6M, no discount rate.
- Acquisition = $200K, 10,795,000 fully diluted shares.
- Outcome = converted Safe amounts to about $3.2K which is far lower than the initial Safe investment of $100K. Investor would elect to not convert and cash out the Safe.
Example 6, No Liquidity event, Safe Valuation Cap, No discount = In this scenario the company becomes cash flow positive and decides not to raise additional equity. Given the Safe has no term, it will remain outstanding until the company has a liquidity event.
Example 7, Equity Financing, Safe Cap, With Discount = The discount rate is applied to the price per share of the standard preferred stock. In this scenario the price per share of the Safe ($0.73 / share) based on the valuation cap is lower than the discounted Series A preferred price ($0.77 / share). Given the Safe price amounts to more shares the Safe investor will convert to Series A-1 Preferred and the discount rate does not apply.
Parameters:
- Safe = $100K, valuation cap $8M, discount rate 85%.
- Equity financing = $1M Series A preferred, $10M pre, 11M fully diluted shares.
- Outcome = Safe converts to Series A-1 Preferred at a value 1.25X initial investment.
Example 8, Equity Financing, No Valuation Cap, With Discount = In this example there is no valuation cap. The discount rate is simply applied to the standard preferred stock price per share and the Safe is converted to the discounted Series A-1 price.
Parameters:
- Safe = $20K, no valuation cap, discount rate 80%.
- Equity financing = $400K, $2M pre, 10.5M fully diluted shares.
- Outcome = Safe converts to Series A-1 Preferred at a value 1.25X initial investment.
Example 9, Acquisition, No Valuation Cap, With Discount, and Liquidity Cap = In this case company and Safe investor also have a cap that is applied in case of a Liquidity Event. Using the liquidity cap, the price per share is $0.40 whereas the acquisition price is $0.16. The value of the acquisition on a converted basis is $19.8K which is lower than the $50K investment. Therefore the investor will elect to cash out of the Safe.
Parameters:
- Safe = $50K investment, no valuation cap, discount rate 90%, Liquidity cap $5M.
- Acquisition = $2M valuation, 12.5M fully diluted shares.
- Outcome = investor does not convert common and cashes out of the Safe.
