SAFEs: Hybrid Pre/Post-Money
- ECompany Capitalization
- ELiquidation Priority
- EDividend Right
- EPro Rata Rights
- ETax Treatment
Y Combinator introduced the Simple Agreement for Future Equity (SAFE) in 2013. And for reasons described here, YC amended the Pre-Money version of the SAFE and introduced a Post-Money version of the SAFE in 2018 (available for download here).
Since then, the question of which SAFE version to use has confused many founders (and the Pre-Money SAFE is no longer available on YC’s website). While YC notes that the biggest advantage of the Post-Money SAFE is the ability to immediately calculate the amount of ownership sold, many founders ultimately decide that the increased dilution resulting from the new definition of “Company Capitalization” in the Post-Money SAFE is not worth this benefit (more on that here). Despite this new dilution issue, YC had 5 years from the introduction of the original SAFE to receive feedback from founders and investors and many positive edits were introduced in the 2018 Post-Money SAFE.
Rather than choose one version or the other, we most often use a hybrid of both SAFEs with our clients which incorporates the clauses of each version that make the most sense. Our reasons for using each clause are explained in greater depth below.
The 2018 version of the SAFE is known as the “Post-Money SAFE” because, for SAFEs with a valuation cap, the valuation is based on the value of the company after the investment (referred to as the “post-money valuation” in venture financings). This made it immediately possible to calculate how much of the company was being sold/purchased simply by dividing the investment amount by the post-money valuation cap (purchasing a $500K SAFE with a $10M valuation cap = 5% of the company). But, this also means that the percentage of the company sold with each SAFE is static and will remain the same throughout future funding rounds—if the company later sells a Post-Money SAFE at an increased $20M valuation cap, the SAFE holder with the earlier $500K SAFE will still own 5% of the company when the SAFE converts—all of the SAFEs will dilute the company’s existing shareholders, but will not dilute other SAFEs (or any other security that converts with it). YC accomplished this in the Post-Money SAFE, by changing the definition of “Company Capitalization” to include “Converting Securities.” Converting Securities refers to the SAFE, all other SAFEs, and any other convertible securities issued prior to the preferred financing that is triggering the SAFE’s conversion.
The definition for “Company Capitalization” can be found in Section 2 of both the Pre-Money and Post-Money SAFEs (with a valuation cap).
Here is the original Pre-Money SAFE definition of Company Capitalization:
“Company Capitalization” means the sum, as of immediately prior to the Equity Financing, (without double counting) of: (i) all shares of Capital Stock (on an as-converted basis) issued and outstanding, assuming exercise or conversion of all outstanding vested and unvested options, warrants, and other convertible securities, but excluding (A) this SAFE; (B) all other SAFEs; and (C) convertible promissory notes; and (ii) all shares of Common Stock reserved and available for future grant under any equity incentive or similar plan of the Company.
Here is the Post-Money SAFE defition of Company Capitalization and Converting Securities:
“Company Capitalization” is calculated as of immediately prior to the Equity Financing and (without double counting, in each case calculated on an as-converted to Common Stock basis):
- Includes all shares of Capital Stock issued and outstanding;
- Includes all Converting Securities;
- Includes all (i) issued and outstanding Options and (ii) Promised Options; and
- Includes the Unissued Option Pool, except that any increase to the Unissued Option Pool in connection with the Equity Financing shall only be included to the extent that the number of Promised Options exceeds the Unissued Option Pool prior to such increase.
“Converting Securities” includes this SAFE and other convertible securities issued by the Company, including but not limited to: (i) other SAFEs; (ii) convertible promissory notes and other convertible debt instruments; and (iii) convertible securities that have the right to convert into shares of Capital Stock.
For the template hybrid SAFE version we used the Pre-Money SAFE definition of Company Capitalization (which does not include the SAFEs and other converting securities).
Note that SAFEs with only a discount rate (and no valuation cap) will not have a Company Capitalization definition as the price per share for the SAFEs with only a discount rate is simply a discount to the lowest price paid by the preferred investors in the equity financing that converts the SAFE. Therefore, the Pre-Money/Post-Money Company Capitalization dilution issue is a moot point for the discount only SAFEs. Nonetheless, the hybrid SAFE template includes a discount only version which we’ve made easier to fill in and execute (we think).
Note: Although using the Pre-Money SAFE definition of Company Capitalization will not dilute founders as much as the Post-Money SAFE version, founders should still understand that SAFEs will cause dilution and calculate the impact to the cap table at conversion.
YC created the SAFE as an alternative to the convertible note (which is an “equity-like” debt instrument) that would be treated like equity in practice. For this reason, SAFEs do not accrue interest or have a maturity date. And while most founders and investors view SAFEs as deferred or unpriced equity (because the investor ultimately wants equity in the company, not repayment of the SAFE), the tax treatment of SAFEs has been uncertain with the authorities often viewing the Pre-Money SAFE as a derivative instrument, similar to a variable prepaid forward contract.
This results in the SAFEs being treated as open transactions by the tax authorities and the SAFE holders having a legal priority repayment ahead of existing equity holders. To negate this debt-like treatment, YC added more equity-like features to the Post-Money SAFE, such as the new express liquidation priority. In a liquidation event, the SAFEs are treated like already converted preferred shares so that the SAFE holders will be paid out after the company’s legitimate creditors/debt holders, but before the common shareholders. Additionally, the SAFE will be paid out on an as-converted to common shares basis if that would result in a larger payout for the SAFE holders (a traditional right of preferred stock).
Because the intent of the SAFE is for the purchase amount to convert into preferred shares and because the liquidation priority provides better tax treatment, we’ve used the Post-Money SAFE’s more equity-like liquidation priority.
The liquidation priority can be found in Section 1(d) of the Post-Money SAFE and the template hybrid SAFE.
Liquidaton Priority. In a Liquidity Event or Dissolution Event, this SAFE is intended to opearte like standard non-participating Preferred Stock. The Investor’s right to receive its Cash-Out Amount is:
(i) Junior to payment of outstanding indebtedness and creditor claims, including contractual claims for payment and convertible promissory notes (to the extent such convertible promissory notes are not actually or notionally converted into Capital Stock);
(ii) On par with payments for other SAFEs and/or Preferred Stock, and if the applicable Proceeds are insufficient to permit full payments to the Investor and such other SAFEs and/or Preferred Stock in proportion to the full payments that would otherwise be due; and
(iii) Senior to payments for Common Stock.
The Investor’s right to receive its Conversion Amount is (A) on par with payments for Common Stock and other SAFEs and/or Preferred Stock who are also receiving Conversion Amounts or Proceeds on a similar as-converted to Common Stock basis, and (B) junior to payments described in clauses (i) and (ii) above (in the latter case, to the extent such payments are Cash-Out Amounts or similar liquidation preferences).
In the Pre-Money SAFE, the SAFEs were treated as debt in a liquidation event and would be paid out along with the company’s creditors who have the most senior priority, above all equityholders (shareholders). The Post-Money liquidation priority in the Hybrid SAFE treats the SAFEs as if it had already converted to preferred shares prior to the liquidation event. Preferred shares are always senior in priority to common shares.
Note: While the Post-Money SAFE’s equity-like liquidation priority means that the SAFE holders will not be paid out with the company’s creditors, the liquidation priority still treats the SAFEs as converted preferred shares with a senior priority to the company’s common shares. Since the intent of the SAFE is for it to convert into preferred shares in this future, this priority aligns with the spirit of the SAFE.
Another equity-like feature YC added to the Post-Money SAFE is the dividend right. The Pre-Money SAFE explicitly stated that the SAFE was not to have any rights of a company shareholder, including the right to vote and the right to receive dividends. Although the Post-Money SAFE still expressly does not have voting rights, it now includes a right for the SAFE holders to a dividend if and when the company pays a dividend on the common stock.
The “Dividend Amount” was added to the Section 2 definitions of the Post-Money SAFE and the right to the dividend is reiterated at the end of Section 5(c) (and can be found in the same sections in the hybrid SAFE template.
“Dividend Amount” means, with respect to any date on which the Company pays a dividend on its Common Stock, the amount of such dividend that is paid per share of Common Stock multiplied by (x) the Purchase Amount divided by (y) the Liquidity Price (treating the dividend date as a Liquidity Event solely for purposes of calculating such Liquidity Price).
. . . However, if the Company pays a dividend on outstanding shares of Common Stock (that is not payable in shares of Common Stock) while this SAFE is outstanding, the Company will pay the Dividend Amount to the Investor at the same time.
Because SAFEs do not automatically convert into equity until the sale of preferred stock, there is always a risk that the startup will become so profitable as an operating business that it doesn’t need to sell preferred stock after the issuance of the SAFE leaving the SAFE outstanding indefinitely (until the company is sold or liquidated). Thus, the dividend right also makes sense for the intended purpose of the SAFE–to convert into preferred shares in the future. If the SAFE does not convert but the company is so successful that the board declares a dividend to the existing shareholders, then the SAFE holders will also receive a dividend as if the SAFE had been converted into equity.
Note: In practice, dividends are generally only issued by mature companies and it is unlikely that the startup would issue a dividend before the SAFEs have converted into equity. However, the more equity-like feature of a dividend right adds to view that the SAFE should be treated as equity rather than debt for tax purposes.
Pro Rata Rights
The Pre-Money SAFE gave the SAFE holder the right to purchase its pro rata share of securities sold after the equity financing via a separate pro rata rights agreement. This pro rata right was given to all Pre-Money SAFE investors, including investors whose SAFE purchase amount were nominal. The language of the pro right was also very awkward as it gave the SAFE investor the opportunity to purchase securities up to its pro rata share after the equity financing. It was never clear if this meant that the SAFE investor could participate in the equity financing or the company had to hold a separate sale solely for SAFE investors after the equity financing. This sometimes caused issues in the startup’s equity financing (usually the Series A round) with VC investors who would have to negotiate to have this right removed or amended. The languge from the Pre-Money SAFE is below.
Notably, YC did not include any automatic pro rata right for SAFE holders the subsequent Post-Money SAFE version, and instead provided a separate pro rata rights letter template on its website which the company can offer to specific investors in connection with the Post-Money SAFE. We agree that the pro rata right should not be automatic and therefore did not include it in the hybrid SAFE template.
Note: From an investor’s perspective, the pro rata right is desirable. However, an investor who purchases a $10k SAFE, should generally not be offered a pro rata right as opposed to an investor who purchases a $100k SAFE. Additionally, investors who purchase SAFEs in nomimal amounts (usually individual Angel investors and friends and family) generally cannot afford to purchase the pro rata share of securities at the price per share after the equity financing. Therefore, the pro rata right should really only be offered as an incentive for certain strategic investors and minimum SAFE purchase amounts.
Tax Treatment Clause
For the avoidance of any doubt (from the taxing authorities), YC also added an explicit clause in the Post-Money SAFE which expressly states that the SAFE should be treated as common stock (equity) for tax purposes. While there is no gaurantee that the taxing authorities will agree that the SAFE is an equity-instrument just because the SAFE states that it is, this certainly adds more clarity to the parties’ express intent.
The tax treatment clause can be found in Section 5(g) of the Post-Money SAFE and the hybrid SAFE template, as shown below.
The parties expressly acknowledge and agree that for United States federal and state income tax purposes this SAFE is, and at all times has been, intended to be characterized as stock, and more particularly as common stock for purposes of Sections, 304, 305, 306, 354, 368, 1036 and 1202 of the Internal Revenue Code of 1986, as amended. Accordingly, the parties agree to treat this SAFE consistent with the foregoing intent for all United States federal and state income tax purpose (including, without limitation, on their respective tax returns or other informational statements).
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