Our Hybrid Version of the SAFE
- ECompany Capitalization
- ELiquidation Priority
- EDividend Right
- ETax Treatment Clause
- EPro Rata Rights
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 dilution issue, YC had 5 years from the introduction of the original Pre-Money SAFE to receive feedback from startups and investors and many positive edits were introduced in the 2018 Post-Money SAFE.
Rather than choose one version or the other, the hybrid SAFE version we use with our clients incorporates the clauses of each version that make the most sense. Each clause is explained in greater depth below.
Pre-Money Company Capitalization
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 — 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.
For the hybrid SAFE with the valuation cap, we’ve kept the Pre-Money SAFE definition of Company Capitalization (does not include the SAFEs and other converting securities).
SAFEs with only a discount rate (and no valuation cap) will not have this 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 shareholders in the equity financing. Thus, the Pre-Money/Post-Money dilution issue is a moot point for the calculation of the discount only SAFEs. Nonetheless, our hybrid SAFEs include a discount only version which we’ve made easier to fill in and execute (we think).
The definition for “Company Capitalization” can be found in Section 2(d) of the template Hybrid SAFE.
Founders: While using the Pre-Money SAFE definition of Company Capitalization will result in less dilution for the existing shareholders when the SAFEs convert, that should not be a open invitation to enter into numerous SAFEs without calculating the impact on the cap table at conversion.
Investors: Although the Post-Money version of the SAFE is more predictable for investors, that version has not been widely adopted by founders outside of YC startups. Because any SAFEs issued with the Pre-Money definition of Company Capitalization will dilute eachother at conversion, it is always best to inquire into a startup’s fundraising plans (including how much will be raised in that SAFE round and any anticipated subsequent SAFE rounds) before purchasing a SAFE.
Post-Money Liquidation Priority
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 template Hybrid SAFE.
Founders: 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.
Investors: 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.
Post-Money Dividend Right
Another equity-like feature YC added to the Post-Money SAFE is the dividend right. The Pre-Money SAFE explicitly stated that the was not to have any rights of a company shareholder, including the right to vote and the right to receive dividends. The Post-Money SAFE still expressly does not have voting rights, a right to any dividends if and when declared by the company’s board of directors was added.
The dividend right was added to Section 5(c) of the Post-Money SAFE and is included in the same section of the Hybrid SAFE. The definition of “Dividend Amount” can be found in Section 2(h) of the Hybrid SAFE.
Founders: In practice, generally only mature companies issue dividends to equityholders and it is unlikely that the company 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. Additionally, the SAFE holders will receive a dividend right if/when the SAFE converts into equity.
Investors: Because SAFEs do not automatically convert into equity (until the sale of preferred stock) there is always a risk that the startup becomes so profitable as an operating company 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 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 decides to issue a dividend to the existing shareholders, the SAFE holders will also receive a dividend as if the SAFE had been converted into equity.
Tax Treatment Clause
For the avoidance of any doubt, in the Post-Money SAFE, YC also added an explicit clause that the SAFE should be treated as common stock 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.
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. Because this pro rata right was given to all Pre-Money SAFE investors, including investors whose purchased amount was nominal, this sometimes caused issues in the equity financing with VC investors negotiating to have this right removed for all but the larger SAFE holders. Notably, YC did not include an automatic post-equity financing pro rata right for all SAFE holders, and instead provided a separate pro rata rights letter 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 did not include it in the Hybrid SAFE.
Founders: The pro rata right can be offered as an incentive to strategic investors or as with a minimum SAFE purchase amount requirement.
Investors: From an investor’s perspective, the pro rata right is desirable. However, an investor who purchases a $500k SAFE, should generally be offered a pro rata right as opposed to an investor who only purchases a $5k SAFE. Additionally, an investors who purchases SAFEs in nomimal amounts (usually, an individual Angel investor) generally cannot afford to purchase its pro rata share of securities at the price per share after the equity financing.
Disclaimer: The information in this page is intended for general educational purposes only. This information may not reflect the current law in your jurisdiction and should not be construed as legal advice or an advertisement for legal services. You should not act or refrain from acting on the basis of any information in this post or accessible through this website. If you have questions regarding your particular facts and circumstances, seek counsel from an experienced startup lawyer.