Bridging the Funding Gap: Adapting SAFE for Deep-Tech Challenges

November 2023

We are currently witnessing a significant downturn in startup financing, a stark contrast to the unprecedented highs of 2021. The market is fraught with uncertainty, and this volatility has been particularly evident in Europe, where venture capital (VC) fundraising has dropped by a staggering 60% compared to the previous year. The tightening of financial conditions and macroeconomic headwinds have forced many startups to reassess their growth trajectories. Companies that have missed their revenue and business projections are now grappling with ways to bridge the valuation gaps that have emerged between investor expectations and their own aspirations.

In Europe, the startup ecosystem primarily relies on standard financial instruments such as Seed and Series A/B funding rounds, Convertible Loan Notes (CLNs), and Venture Debt. These instruments have traditionally served as the backbone of startup financing. However, their suitability for certain types of startups—especially deep tech companies—has come into question amidst the current downturn. Deep tech startups, characterized by long R&D cycles and capital-intensive development, often struggle to meet their projected milestones. This makes them particularly vulnerable to funding crunches, as they frequently require more time and capital to achieve profitability or scalability.

A serious question arises in this context: is there an effective way to use SAFEs as a tool for deep tech companies? SAFEs have become a popular instrument for early-stage financing in US, offering a simplified and flexible approach compared to traditional equity rounds. However, they are typically designed for smaller investments and are most commonly associated with seed-stage startups in high-growth sectors like SaaS or consumer technology. For deep tech companies, which are often in perpetual fundraising mode due to their unique challenges, SAFEs could potentially be adapted to meet their early needs.

Could there be a case for larger SAFE instruments tailored specifically for deep tech companies? A larger SAFE instrument might allow these companies to secure the significant capital they need without the immediate pressure of determining valuation or restructuring equity. By deferring valuation discussions until a later stage, such instruments could provide much-needed runway for R&D and allow founders to focus on achieving critical milestones. Investors, on the other hand, could benefit from favorable conversion terms, such as valuation caps and discounts, that align with the risk profile of these ventures.

First, we would like to go through the idea of the SAFE note and its features to asses if it makes sense for larger rounds.

What is a SAFE Note?

A SAFE (Simple Agreement for Future Equity) is a financial instrument commonly used in startup financing. Unlike traditional stocks or debts, a SAFE is a contractual agreement that allows investors to exchange their investment for equity in the company at a future financing event. This means that rather than owning a part of the company right away or being owed a repayment like with loans, SAFE investors will receive shares based on the terms agreed upon at a later stage. The conversion price of a SAFE is typically linked to the valuation of this future financing round, often including protective provisions such as a valuation cap or a conversion discount. These features are designed to incentivize early participation and safeguard investors’ interests.

When comparing SAFEs to convertible notes, which are also tools for early-stage investment, several key differences emerge. One significant distinction is the maturity of the instruments. Convertible notes have a set maturity date, meaning that the company must either repay the investment or convert it into equity by that date. In contrast, SAFEs have no maturity date, providing startups with more flexibility. Additionally, convertible notes accrue interest, creating an ongoing financial obligation for the company. SAFEs, however, do not incur interest, allowing startups to maintain better cash flow.

Another notable difference lies in the priority of repayment. In the event of liquidation, convertible notes typically have seniority over existing preferred stock, meaning they must be paid back before other equity holders. SAFEs are treated equally with preferred stock, sharing the same priority in repayment.

The benefits of SAFEs for startups are considerable. They simplify the fundraising process, requiring less negotiation and paperwork compared to traditional equity financing. This streamlined approach enables startups to focus more on their operations. Moreover, because SAFEs are not classified as debt, startups don’t face the pressure of making interest payments or repaying principal amounts, thus helping them conserve valuable resources, particularly during early growth stages. SAFEs also allow startups to defer complex valuation discussions until later financing rounds, when more data and metrics are available to support a more accurate assessment.

For investors, SAFEs present the potential for higher returns. They enable early investment in high-growth startups, often on favorable terms such as discounts or valuation caps, which can lead to significant upside as the company progresses. Furthermore, the standardized SAFE agreement simplifies the investment process, cutting down on legal complexities and facilitating quicker transaction closures. This efficiency benefits both investors and startups alike, promoting a smoother path to growth.

How SAFE works ?

A SAFE, or Simple Agreement for Future Equity, serves as a flexible and straightforward financial instrument primarily used by startups to secure capital during their early financing rounds. The process begins when an investor and a company reach an agreement on the terms of the SAFE. A pivotal element of this agreement is the valuation cap, which establishes a maximum valuation at which the SAFE can convert into equity in the future. In some instances, the SAFE might also include a discount rate, offering the investor the opportunity to convert their investment into equity at a favorable price compared to other investors in upcoming financing rounds. The investment terms are officially formalized when both parties sign the SAFE agreement. After execution, the investor will then deposit the funds into the company. Unlike more traditional debt instruments, a SAFE doesn't carry interest payments or a maturity date. Rather than an immediate exchange of cash for equity, the SAFE entitles the investor with the right to convert the investment into equity upon the occurrence of specified future events.

The true essence of a SAFE lies in its conversion feature, which takes effect when a conversion event occurs. Such events can include significant milestones such as a priced round of financing, a company sale, an initial public offering (IPO), or even the company’s dissolution. When these events happen, the SAFE converts into equity, typically in the form of preferred stock.

The most prevalent scenario for conversion is during an equity financing round, like a Series A or Series B funding round. During this process, the SAFE's conversion terms hinge upon the company’s pre-money valuation in the financing round in relation to the agreed-upon terms in the SAFE.

If the pre-money valuation exceeds the established valuation cap, the SAFE holder converts their investment into equity based on that cap price, allowing them to receive shares at a cost lower than that of new investors in the round. This provision serves to reward early investors for taking on additional risk. Conversely, if the pre-money valuation is below the valuation cap, the SAFE holder simply converts their SAFE into preferred stock at the same terms as other participants in the financing round, meaning the cap has no bearing on the conversion.

Once the SAFE transforms into equity, the investor becomes a shareholder, generally acquiring pro rata rights. These rights are beneficial as they allow the SAFE holder to maintain their ownership percentage in subsequent funding rounds by purchasing additional shares, ensuring they can uphold their stake as the company progresses.

In addition to equity financings, SAFEs may convert during liquidity events, such as mergers, acquisitions, or IPOs. In a merger or acquisition scenario, a SAFE holder can choose to convert their SAFE into common stock at the valuation cap price or opt to receive back their original investment — a decision contingent upon which alternative proves more advantageous. If the company goes public, the SAFE also converts into common stock at the valuation cap price, although the holder might prefer to cash out, opting for liquidity over equity in the public entity.

One key advantage of SAFEs lies in their lack of expiration. Unlike convertible notes, which have a maturity date, a SAFE remains valid until a conversion event takes place, thus offering flexibility for both investors and the company without the pressure of a specific deadline. Moreover, in the unfortunate event of a company's dissolution, SAFE holders have a priority claim over common stockholders for any available funds, providing a layer of protection for investors.

There are also alternative versions of the standard SAFE, each designed to cater to different investor and startup needs. For instance, some variations may incorporate both a valuation cap and a discount rate, allowing the SAFE to convert based on whichever option is more favorable for the investor—whether it be the valuation cap or a discounted price per share. Such alternatives can offer additional benefits or protections tailored to the specific circumstances surrounding the investment.

SAFE & CLN

A SAFE Note and a CLN stand out as two of the most widely adopted instruments in the financing of early-stage startups. Each of them is designed to provide investors with a route to convert their investment into equity on a future date. But they are far different in their structure and terms, and therefore understanding these differences becomes very important for both startups and investors while choosing an apt financing option.

As said earlier, the primary characteristic of a SAFE Note is that it is neither debt nor equity. It serves as a contractual right that allows the investor to convert their investment into equity at a later date. Unlike traditional debt instruments, a SAFE does not accrue interest, and it does not confer ownership until conversion occurs. One of the key advantages of a SAFE Note is its simplicity; it lacks a maturity date and does not accumulate interest. This feature alleviates the pressure that borrowers often feel to repay the investment within a specific timeframe.

Conversions under a SAFE Note occur automatically once certain triggering events take place. These events typically include a priced round of financing but can also encompass other significant occurrences, such as the sale of the company or an initial public offering (IPO). The terms of conversion are outlined in the SAFE agreement, and the conversion price is determined based on the company's valuation at the time of financing.

Key terms associated with a SAFE Note include the valuation cap, discount rate, and Most Favored Nation (MFN) clause. The valuation cap establishes a maximum price for conversion into equity, protecting early investors from high valuations during subsequent financing rounds. The discount rate allows the SAFE holder to convert their investment at a rate lower than that of later investors, incentivizing early contributions and risk taking. The MFN clause permits SAFE investors to adjust their agreement to match more favorable terms provided to later investors.

When it comes to conversion mechanics, SAFE Notes convert automatically at the occurrence of a qualifying financing event, although the SAFE holder must sign the appropriate agreements related to that round. If the company faces non-financing events like a sale or liquidation prior to conversion, the SAFE investor generally retains the right to their original investment back, unless conversion would yield a more significant payout.

Upon conversion, the SAFE investor may receive either Standard Preferred Stock or a special class of shares, contingent on whether the conversion terms include a valuation cap or discount. Furthermore, the SAFE agreement includes limited representations and warranties, primarily concerning the startup’s compliance and ownership of intellectual property. Amendments to SAFEs typically require the majority consent of holders, and any transfer of SAFEs usually necessitates the company's approval to ensure that ownership remains within the original parties.

In contrast, a Convertible Loan Note (CLN) resembles a traditional loan structure while incorporating certain unique characteristics. A CLN is fundamentally a debt instrument, meaning the company borrows money from the investor and assumes the obligation to repay the loan under specific conditions. Unlike a SAFE, a CLN typically accrues interest and includes a maturity date by which the company must either repay the loan or convert it into equity. This structure places the company under pressure to act, since failure to convert prior to the maturity date requires repayment of the principal plus interest.

Similar to SAFEs, a CLN also allows for conversion upon certain triggering events, such as future financing rounds or acquisitions. However, the terms of conversion—including the valuation cap and discount rate—mirror those found in SAFEs to ensure that early investors are afforded favorable treatment during conversion.

Overall, while both SAFE Notes and Convertible Loan Notes facilitate the conversion of investments into equity, their distinct structures and terms cater to different needs and preferences in the realm of startup financing. Understanding these differences is essential for startups and investors alike, paving the way for successful funding decisions.

Advantages and Disadvantages of SAFE

The SAFE, has become a popular choice for early-stage fundraising, celebrated for its straightforward nature, speed, and adaptability. However, like any financial instrument, it comes with its own set of advantages and disadvantages that both startups and investors should carefully consider.

One of the most attractive features of a SAFE is simplicity. The deal is simple to grasp and does not involve the complex structures that often define traditional equity financing. In this respect, it is faster to conduct fundraising and also for firms to focus on their core business while still securing the needed capital, likely with less extended negotiation processes and documentation.

Second, SAFEs are relatively cheaper than most other fundraising techniques, such as convertible notes or equity rounds. For cash-starved early-stage startups, saving on legal and administrative expenses could be a substantial difference. Another interesting feature is that an immediate valuation is not required. Startups in the initial phases may lack a clear market value, which makes the ability to defer valuation until the company has more traction very advantageous. This flexibility allows companies to secure funding without the pressure of committing to a potentially premature valuation.

Furthermore, SAFEs provide a flexible fundraising structure. Startups can tailor agreements to fit their needs and those of their investors, incorporating common terms such as valuation caps and discounts. This customization makes SAFEs appealing across various investment scenarios. Unlike convertible notes, SAFEs do not accrue interest, relieving startups of additional financial burdens and allowing them to conserve cash flow.

Another advantage of SAFEs is the absence of a maturity date. With no fixed repayment or conversion dates, startups enjoy greater flexibility, deferring conversion events until they are ready. This lack of urgency allows businesses to grow at their own pace without the pressure of meeting deadlines. Founders also retain control over their company, as SAFEs do not grant investors voting rights or board seats until conversion occurs. This preservation of control is crucial during the early stages of growth.

From an investor's perspective, SAFEs present the potential for significant upside. Early investors can secure equity at favorable prices before the company grows, benefiting from terms like valuation caps and discounts that protect their interests. Moreover, SAFEs can efficiently scale to accommodate multiple investors under consistent terms, simplifying the fundraising process and allowing for easier integration of new investors.

However, despite these advantages, SAFEs also carry notable disadvantages that warrant attention. One major concern for investors is the uncertainty surrounding their investment. Since conversion relies on future events like financing rounds or liquidity events, investors are at risk of their funds remaining in limbo if the company never reaches these milestones. The timing and valuation of conversion can also be uncertain, which directly impacts the potential return on investment.

In contrast to convertible notes, SAFEs lack a fixed repayment or maturity obligation, creating a risk for investors who appreciate knowing when their investment will be converted into equity. Furthermore, the potential for over-dilution looms large for startups that issue multiple SAFEs with different terms. Significant dilution of ownership can occur during conversion, particularly for companies repeatedly raising funds through SAFEs with varying conditions.

In summary, while SAFE notes offer a mix of simplicity, flexibility, and cost-effectiveness that can greatly benefit early-stage startups, they also bring uncertainties and risks that investors must carefully weigh. As the landscape of fundraising continues to evolve, both parties need to navigate these trade-offs to ensure a successful partnership.

SAFE & Valuation

A SAFE is an important tool in the world of early-stage fundraising. It allows startups to raise capital without having to immediately establish a formal valuation of the company. This delay in valuation is one of the key features of a SAFE, though it comes with complexities that may impact future funding rounds and the perceived value of the company.

One of the primary attributes of a SAFE is that it does not necessitate an initial valuation at the time of funding. Instead, the valuation is deferred until a later date, often during a subsequent equity financing round. This aspect is particularly advantageous for nascent startups that may lack the financial metrics, market traction, or customer base necessary to determine a reliable valuation. Early-stage companies frequently grapple with establishing a clear market value due to the absence of historical performance data. SAFEs provide these startups with the flexibility to raise funds without the immediate pressure of assigning a potentially inaccurate or premature valuation.

This deferral of the valuation decision will allow startups to wait until they have a more refined understanding of their growth trajectory, performance, and market conditions. Often, this results in a more precise and favorable valuation in future rounds, since the company's worth will reflect its accomplishments and milestones rather than mere speculative estimates.

Many SAFE agreements incorporate a valuation cap, which serves as a safeguard for investors by capping the maximum valuation at which the SAFE can convert into equity during a future financing round. This cap ensures that investors aren’t excessively diluted if the company's valuation surges in later funding rounds. For instance, if a SAFE includes a $5 million valuation cap and a future priced round values the company at $10 million, the SAFE holders will convert their investment at the capped amount of $5 million. Consequently, they receive more equity for their investment, thereby increasing their ownership percentage relative to new investors who enter at the higher valuation. This mechanism rewards the early investors for taking on the risks of investing at such an uncertain stage.

Along with the caps, most of the SAFEs also include a discount rate that enables the investor to convert their SAFE into equity at a price lower than what the new investors will pay in future rounds. A typical discount rate may be 20%, so when the company is valued at the next round at $10 per share, a SAFE investor will convert their investment into equity at $8 per share. This lower effective price per share makes SAFEs more attractive to early investors because they may eventually own a bigger percentage of the company and also enjoy a higher share of future growth.

As SAFEs convert into equity, typically during a priced round, they can dilute the ownership percentages of founders and other existing shareholders. The post-money valuation, which represents the company’s valuation after the new financing round, must account for this conversion. The increase in shares outstanding due to SAFE conversions can lower the effective valuation per share for other stakeholders. For example, if a startup raises $2 million through SAFEs and these investors convert at a $5 million cap, the dilution for existing shareholders can be significant, especially if the actual valuation during the next round is considerably higher. Thus, while SAFEs provide essential flexibility and benefits for startups and early investors alike, they also introduce important considerations regarding ownership and valuation dynamics.

Considerations while using SAFE

When considering SAFE (Simple Agreement for Future Equity) agreements as a means of raising capital, both startups and investors must navigate a variety of key factors to ensure a fair and transparent investment process. These considerations range from the fundamental understanding of valuations to more complex issues, such as dilution, the implications of co-existing SAFEs, and control mechanisms within the investment landscape.

Understanding pre-money and post-money valuations is essential. Pre-money valuation refers to the company's worth before new capital is injected during a funding round. It serves as the basis for investors’ decisions and helps establish the price per share for the new round of funding. Conversely, post-money valuation represents the company’s value immediately after the capital has been raised, incorporating the new investment. This distinction becomes particularly crucial when dealing with capped SAFEs, as the valuation cap typically applies to the pre-money valuation. Essentially, this means that if a company’s valuation exceeds the cap at the time of conversion, SAFE holders gain a more advantageous conversion price based on the capped pre-money valuation rather than the post-money valuation. Both founders and investors need to grasp this concept clearly to avoid any misunderstandings about dilution during conversion events.

Another significant concern is dilution, which occurs when new shares are issued, reducing the ownership percentage of existing shareholders. For founders, dilution can directly affect their control over the startup. Investors, too, must carefully assess how ownership may shift once the SAFE converts into equity. This is more so the case when a startup raises multiple rounds of funding, especially if these rounds are done using SAFEs with different terms. Dilution potential has to be looked at carefully to ensure that the ownership structure is not compromised and that neither party's interests are compromised.

Equally important is the impact of the option pool, which is a reserve of shares allocated for employee stock options. Typically established before a funding round, the option pool is often considered in the company’s post-money valuation and can significantly affect ownership stakes. If the option pool is created after the SAFE conversion but before a priced equity round, it may lead to additional dilution for existing shareholders. Startups should be judicious in determining the size of the option pool, while investors should evaluate its implications on their potential returns. An oversized option pool can excessively dilute both founders’ and investors’ equity, diminishing overall value.

Furthermore, startups may issue multiple SAFEs to gather capital from various investors, each with differing terms, such as varying valuation caps and discounts. This variability can complicate the conversion process during future funding rounds. It is vital to be aware of how these differing terms interact, as discrepancies can lead to dissatisfaction among investors. For instance, if some SAFEs have lower valuation caps than others, their conversion will yield a more significant equity stake for those investors, potentially creating tension with those holding SAFEs with higher caps. Therefore, clear communication and understanding among stakeholders become essential to mitigate conflicts arising from such disparities.

Navigating these complexities of SAFE investments requires diligence and strategic planning to ensure that all parties remain informed and aligned in their expectations throughout the investment process.

Potential Conflicts

In the world of startups and venture capital, disputes related to SAFE can often emerge. These disagreements usually stem from misaligned expectations, unclear terms, or misunderstandings among the various stakeholders involved—founders, investors, and future backers.

One common source of tension is the misalignment of valuation caps. For instance, imagine a startup that raises $1 million through SAFEs with a cap set at $5 million. Later, during a priced equity round, the company's valuation skyrockets to $15 million. As a result, the SAFE investors convert their agreements based on the $5 million cap, which leads to significant dilution for the founders and early investors. In this scenario, founders might feel that the terms were overly favorable to the early investors, while later-stage investors may find the resulting equity structure unfairly dilutive.

Another potential conflict arises from the over-issuance of SAFEs. Picture a startup that distributes multiple SAFEs, each with different valuation caps and discount rates, without properly tracking their cumulative impact on the cap table. When it comes time for the priced round, it becomes evident that converting all the SAFEs leads to excessive dilution, leaving the founders with far less equity than anticipated. This may lead to allegations of poor management by founders and subsequent investors alike because they will fault the company for not being transparent about the total effect of the SAFEs.

Timing also brings confusion and conflict. Imagine a situation where a startup raises a tiny bridge round prior to a much larger priced equity round. There exists ambiguity regarding whether this bridge round qualifies as a "triggering event" for the SAFE conversion. While SAFE investors expect their agreements to convert during the bridge round, founders may argue that conversion should only take place during the larger priced round. This division can create a rift, with investors feeling unjustly delayed in receiving their equity and founders asserting that premature conversion could distort the company’s valuation.

Another potential point of contention involves acquisition scenarios that occur before SAFE conversion. If a startup raises funds through SAFEs and is subsequently acquired, but the acquisition valuation falls below the SAFE's valuation cap, disputes can arise regarding the compensation for SAFE holders. In these situations, SAFE holders may contend that the founders manipulated the acquisition terms to undervalue their stakes. Conversely, founders might argue that the acquisition represented the best outcome available under the circumstances.

Additionally, a lack of clarity in the SAFE agreement itself can lead to disputes. If an agreement is vague about pro-rata rights or other post-conversion rights, investors may demand additional equity to maintain their ownership percentage in upcoming funding rounds after conversion. Founders might resist these demands, arguing that the terms were already clear, while investors could insist they are entitled to more equity based on implicit rights.

Relationships can also become strained between founders and their early investors, particularly when friends and family invest. When these early backers feel left out of key decision-making processes or misinformed about investment risks, tensions can rise. Upon conversion of their SAFEs, they may discover their ownership percentages are much less than expected, leading to accusations of misrepresentation from investors and defensiveness from founders who believe the terms were fair and transparent.

This can be followed by tension between the terms of SAFEs and what the later round investors expect. New investors often demand renegotiating the previously issued SAFEs' terms to say that too much cap or discount was given out. The standoff begins as the holders of SAFEs resist such renegotiations, thus making conflicts arise and relationships between early investors, new backers, and even founders are strained.

SAFE Usage and Terms

Startups in technology and innovation, including those focused on Software-as-a-Service (SaaS), mobile applications, and artificial intelligence or machine learning, frequently utilize SAFEs to attract early investment. These tech-centric ventures often boast scalable business models but may struggle to generate initial revenue or achieve profitability in their formative stages. Also, Deep tech and research and development-driven companies, particularly those in the fields of biotechnology and renewable energy, often face significant uncertainties in their early phases. As a result, they may employ SAFEs for seed funding to mitigate risks associated with high research and development costs.

When considering the stages of growth, the pre-seed stage is crucial, as it’s the point when founders are just beginning their entrepreneurial journey. At this stage, they often rely on initial capital from friends, family, angel investors, or accelerators to validate their ideas, build prototypes, or recruit early team members.

As companies transition to the seed stage, they usually have developed a Minimum Viable Product (MVP) or gained early traction. Here, SAFEs become instrumental in securing funding needed to scale their offerings or test market fit, with typical investors including angel investors and venture funds focused on seed rounds. In the early growth stage, some startups raising bridge rounds between larger funding rounds may also resort to SAFEs, finding them a quick, non-dilutive option for securing necessary capital. Overall, SAFEs have become a staple in the financing toolkit for startups across various industries, offering a flexible and efficient means of funding growth during challenging early stages.

In the world of startup investments, several standard terms often surface, particularly in relation to SAFEs

First and foremost is the Purchase Amount, which refers to the upfront capital that an investor provides in exchange for the future right to equity in the company. Unlike convertible notes, this amount does not accrue interest, making it a straightforward investment vehicle.

Another crucial term is the Valuation Cap. This represents the maximum valuation at which a SAFE converts to equity. The presence of a valuation cap is beneficial for investors, especially if the company experiences rapid growth. For instance, if a startup sets a valuation cap at $10 million, but subsequently raises a round at a $20 million valuation, the SAFE investor would convert their investment as if the company were valued at the lower, $10 million cap. Valuation caps can vary significantly based on several factors, including the startup's stage, the industry, its geographical location, and the amount being raised. In 2023, for example, the median post-money valuation cap was $10 million, illustrating a standard benchmark, though economic shifts hint that typical caps may range between $3 million and $5 million for early-stage startups post-2022.

Next is the Discount Rate, a percentage discount applied to the next round’s valuation, which rewards early investors for their risk-taking. Commonly, these rates fall between 10% and 25%, with 20% being the standard. A notable trend emerged in 2023, where approximately 41% of SAFEs featured discount rates deviating from this norm, indicating a response to market uncertainties.

The Most-Favored-Nation (MFN) Clause is another significant term that can often be included in SAFE agreements. This clause ensures that if a company issues another SAFE on more favorable terms, the investor can amend their SAFE to match those better terms. While MFN clauses are sometimes included in later-stage investments, they are more prevalent during early funding rounds, as startups usually wield less negotiating power. Investors may seek these clauses to safeguard against future issuances of SAFEs that might offer lower valuation caps or more advantageous discount rates, ensuring equitable treatment across investment rounds.

Pro Rata Rights are a crucial aspect of investment agreements, allowing investors to participate in future financing rounds to maintain their ownership percentage. This provision is often requested by larger or institutional investors, who see it as an essential safeguard for their equity stake.

When considering SAFEs it’s important to understand the distinction between Post-Money and Pre-Money valuations. A Post-Money SAFE determines the investor's ownership percentage based on the valuation of the company after the inclusion of the amount to be invested under the SAFE. Many investors like this approach because it better reflects their percentage of ownership in the company. Conversely, a Pre-Money SAFE calculates the investor's percentage before the investment to be made via a SAFE is included in the valuation. While Pre-Money SAFEs were historically more common, there has been a noticeable shift toward Post-Money SAFEs in recent years, as they better align the interests of founders and investors.

Conversion Trigger Events are significant occurrences that result in the SAFE converting into equity. The most common triggers include Equity Financing, where the SAFE converts during the next priced funding round; Liquidity Events, such as a sale or IPO, which often come with specific payout terms; and Dissolution Events, where investors may reclaim their purchase amount or a pro-rata share of remaining assets if the company fails.

Valuation and Dilution Protections are essential terms designed to safeguard the investor’s equity in future funding rounds or during restructuring. Market practices typically include standard protections like adjustments to the conversion price in the event of stock splits or similar scenarios. Some SAFEs go further by introducing “shadow series” shares, which differentiate SAFE shares from common shares, ensuring that investors retain their rights and protections.

An attractive aspect of SAFEs is the lack of a maturity date. As opposed to convertible notes, such agreements do not expire or gain interest; they are therefore more friendly to the founder and give a lot of leeway for the startups.

Moreover, there are optional early conversion clauses in some SAFEs that allow investors to convert their stakes even before the next funding round; this, however is not common and often tied to certain terms or negotiations.

Lastly, the Governing Law clause in a SAFE agreement specifies which jurisdiction’s laws will apply, typically aligning with the company’s incorporation. For instance, Delaware law is commonly chosen for Delaware C-corporations, providing a familiar legal framework for all parties involved.

Pointers while modeling SAFEs

When modeling Simple Agreements for Future Equity (SAFEs), it's important to take into account several key considerations to create accurate, transparent, and realistic financial projections. Understanding the complex dynamics of SAFEs is crucial for both startups and investors, as it directly influences the company’s capital structure and valuation.

First and foremost, one must grasp the specific terms and structure of the SAFE. Notably, the valuation caps and discounts play an important role: The valuation cap sets the upper limit price at which the SAFE shall convert into equity, while the discount rate provides investors with a percentage decrease in share price upon the conversion of the same. This indicates that defining these clearly for each separate SAFE issued is critical, especially when there are multiple SAFEs involved, with different caps or discounts. Tracking each SAFE individually becomes critical to accurately calculating their conversion during future funding rounds.

Next, it is essential to model the conversion mechanism itself. SAFEs typically convert during a priced funding round, so anticipating the timing of these financing events—such as a Series A round—is crucial. Additionally, understanding whether the valuation cap applies to the pre-money or post-money valuation can greatly affect dilution. SAFEs with post-money caps tend to cause more dilution as they are based on the company’s valuation after new investments are added.

The impact on ownership must also be carefully analyzed. As SAFEs convert into equity, the ownership percentages of existing shareholders will experience dilution. It’s important to model how each round of SAFE conversions influences the equity stakes of founders, investors, and any employee stock options. Building a pro forma capitalization table can effectively illustrate these changes, presenting both pre-conversion and post-conversion ownership for all stakeholders involved.

Looking ahead, forecasting future fundraising rounds is necessary since SAFEs typically convert when a company raises its next capital. It’s crucial to estimate how much capital will be raised in future rounds and to understand the resulting ownership distribution among SAFE holders after conversion. Additionally, one should factor in the potential dilution from any option pool that may be established during these rounds, as option pool size and timing can vary significantly.

Tracking the conversion of SAFEs based on their respective caps and discounts is another critical aspect. For instance, if a company raises funds at a valuation exceeding the SAFE’s cap, SAFE investors will convert at that capped valuation. Conversely, SAFEs with a discount rate will convert into equity at a discounted price relative to the future round's share price, which favors the SAFE investors compared to new ones.

However, a significant risk associated with SAFEs is the potential for non-conversion, particularly if the company does not engage in subsequent funding rounds. This scenario may arise if a company becomes profitable or if it opts for an exit strategy without raising additional capital. The possibility of no future funding rounds should be modeled carefully to assess its implications for SAFE holders. Moreover, some SAFEs may include clauses for maturity dates, requiring the company either to repay the SAFE with a premium or force conversion if no funding round occurs by a specified date.

Furthermore, the presence of Most-Favored-Nation (MFN) clauses in some SAFEs adds another layer of complexity. These clauses allow earlier investors to adjust their terms to match those of later SAFE investors if the company offers better terms. Therefore, modeling how an MFN clause could influence the conversion terms of earlier SAFEs in the event of changes for new investors is essential.

Finally, for more intricate SAFEs with multiple terms or unique provisions, employing option pricing models can provide valuable insights into their implied value. These models allow for a nuanced understanding of the financial implications, helping to inform both startups and investors on the best path forward as they navigate the evolving landscape of SAFE instruments.

SAFE for Deeptech

To make bigger SAFEs more viable for deep tech, some adjustments

Higher caps: Valuation caps should be more substantial when using larger SAFEs, where investor interests are then far better secured in follow-on rounds.

Tranches: The investment amount would be disbursed as staged, contingent on the company's achievement of specific R&D or business development milestones.

Hybrid Structures: Combining SAFEs with features of convertible notes or venture debt could offer greater flexibility and appeal to a broader range of investors.

While these adjustments could make SAFEs more attractive and practical for deep tech companies, there are inherent risks. Larger SAFE rounds could potentially dilute the equity pool significantly upon conversion, creating challenges for founders and existing stakeholders. Additionally, the flexibility of SAFEs might lead to governance concerns if not carefully structured.