The Old SAFE Was Better
By: Yael Hauser
Tags: Safe, Y Combinator, Legal, Startup

Since its release by Y-Combinator in 2013, the SAFE has provided an attractive alternative to convertible loans (CLAs) for both startup companies and VC funds alike. The SAFE is intended to be an equity alternative to CLAs, which are debt instruments, and therefore free of loan-related terms such as interest accrual or maturity dates. As an equity instrument, a SAFE allows companies to avoid certain pitfalls of CLAs such as the need to withhold Israeli tax on the interest or any discount received. It works well for early stage startups and their founders, helping them easily raise amounts between funding rounds, debt-free, and requiring less negotiation and has fewer strings attached than a full funding round. Eventually, the money invested via the SAFE instrument is exchanged for equity in the context of a funding round. As originally contemplated, the number of shares issuable pursuant to the SAFE are calculated based on a pre-money basis, i.e. the company’s valuation prior to the round (the “pre-money SAFE”).

In 2018, Y-Combinator released an updated SAFE that recalibrated the balance between the company and the investors. The main change, as explained by Y-Combinator, was that the equity to be received by the investor is now calculated on a post-money basis (the “post-money SAFE”). This is an attractive option for both investors and founders, as it allows for immediate calculation of the percentage of shares destined to be issued, irrespective of the round size or other SAFEs outstanding, allowing for greater certainty for both parties. The pre-money SAFE did cause difficulties for investors and companies alike to accurately predict the percentage of company shares being allocated to the investors, because estimating ownership and dilution of shares requires accounting for speculative growth in the upcoming funding round. Put simply, pre-money SAFEs can be confusing to measure prior to a funding round, since other SAFEs or similar instruments being converted during the round will dilute the investor’s final holdings. The change in the post-money SAFE makes sense, as investments via SAFEs have become more common and in fact sometimes replace seed stage financing rounds, plus SAFEs cover much larger sums than originally contemplated, including investments in the millions of dollars.

However, that certainty comes at a price. While the investors are not diluted by other outstanding SAFEs or convertible debt in a post-money SAFE, the existing company shareholders, which are mainly the founders in an early stage startup, are the ones that bear the brunt of this dilution.

In addition, there are other changes that have been made to the post-money SAFE that make the post-money SAFE less attractive to founders and their companies. First and foremost, the post-money SAFE can allow SAFE investors a pro rata right to participate in the financing round that converts the SAFE, as if they were already shareholders at the time of the round. While this right is optional, investors are likely to request this right because the option now exists. The pre-money SAFE did not grant the investors any such pro rata right until after they became shareholders, i.e. in the following financing round, in which case either there would be a separate pro rata rights agreement or they would receive the rights already included for other investors in the financing round. This pro rata participation right has a direct impact on the company’s ability to close a round, and may not leave enough room for both existing shareholders and the new equity investor to fully participate.

The post-money SAFE also contains a statement confirming that the form of SAFE is unchanged from the template. While it is true that SAFEs are supposed to be simple instruments, requiring much less effort to raise money (including by incurring fewer legal fees), sometimes negotiation between the parties is a good thing that tailors the transaction to the needs of both parties. Changes to reflect the commercial understandings of the parties may therefore be required, or even simple technical changes to localize the SAFE, e.g. remove provisions not relevant for Israeli companies such as references to United States federal and state laws or update terms such as “stock” when in Israel a company’s equity is described using “shares”.

Another difference relates to the ability of investors to participate in any distributions of dividends by the company while the SAFE is outstanding. Participation in distributions of dividends are mostly hypothetical since early stage startups likely don’t have sufficient, if any, profits to distribute as dividends, and particularly not if they are fundraising. In any event, the pre-money SAFE explicitly excludes the ability for SAFE investors to participate in any distributions while the post-money SAFE provides for the investors to participate in any dividends on common (ordinary) shares. Existing shareholders would therefore receive a smaller portion of any such distribution in the context of a post-money SAFE, even though the SAFE investors are not yet actual shareholders of the company.

The pre-money SAFE also has some components that are better for the investors than a post-money SAFE. For example, amending the terms of a pre-money SAFE requires simply the mutual consent of the company and the applicable investor. A post-money SAFE makes the amendment a collective choice, such that the consent of the majority in interest of the then-outstanding SAFEs can make changes to the terms of any similar post-money SAFE, other than with respect to the investment amount. Whether the other SAFE investors, to the extent they exist, should have any say in a stand-alone document between an investor and the company is not necessarily beneficial to that investor.

Ultimately, the decision of which SAFE to use (or whether or not to use a SAFE in the first place) is a decision that should be reached mutually by the investors and the company and its founders. But even though the post-money SAFE is newer, in many respects it is not necessarily better.