Demystifying SAFE Note Conversions: Constructing Your Cap Table for Post-Money and Pre-Money

Introduction

For early stage startups raising funds through convertible notes like SAFE (Simple Agreement for Future Equity), it’s crucial to understand how these notes convert to equity and impact your cap table down the line. In this post, we’ll review what SAFEs are, the key terms, and walk through examples of developing a cap table for post-money and pre-money SAFEs.

What are SAFE Notes?

SAFE stands for Simple Agreement for Future Equity. It is a type of convertible note that is commonly used by startups to raise funds in an early seed round. Here are some key features of SAFE notes:

• Converts to equity at a later date – SAFEs do not initially convert to equity when funded. They convert upon a future triggering event like an equity financing or an acquisition.
• No maturity date – Unlike traditional convertible notes, SAFEs do not have a maturity date where the principal becomes due. They convert indefinitely until a triggering event occurs.
• Investor-friendly terms – SAFEs favor investors over the company. For example, SAFEs have a valuation cap that acts as a ceiling on the conversion price.
• Streamlined documentation – SAFE notes use standardized, simple templates that allow fundraising to move quicker.

Now let’s review the key economic terms of a SAFE that impact the conversion and cap table:

Valuation Cap

The valuation cap sets the maximum pre-money valuation that the company can have upon conversion of the SAFE. It serves as a ceiling on the conversion price. For example, if you have a $5M valuation cap and raise a $1M SAFE, the maximum implied valuation upon conversion is $5M.

Discount Rate

The discount rate provides a discount on the conversion price upon a SAFE triggering event. It is a percentage discount to the price paid by investors in the next equity round. For example, a 20% discount rate on a SAFE means converting at a 20% discount to the next round price.

Pro Rata Rights

Pro rata rights give SAFE holders the right to participate in subsequent equity rounds to maintain their ownership percentage. This prevents dilution of their investment as the company raises more capital.

Developing a Cap Table for Post-Money SAFEs

Let’s walk through an example of how to construct a cap table after a SAFE converts upon a post-money safe triggering event like an equity financing.

• Company XYZ raises a $500K SAFE with a $3M valuation cap and 20% discount
• Company XYZ later raises a $1M equity round at $5M pre-money valuation
• The SAFE will now convert along with the new $1M equity round

Step 1) Determine Post-Money Valuation

• Pre-Money Valuation: $5M
• New Equity Round Investment: $1M
• Post-Money Valuation = Pre-Money + New Investment
• = $5M + $1M
• = $6M

Step 2) Calculate Conversion Price

• Post-Money Valuation: $6M
• Discount Rate: 20%
• Non-Discounted Price Per Share = Post-Money Valuation / Total Shares Outstanding
• Total Shares Outstanding = Existing Shares + New Shares from $1M Equity Round
• Let’s assume existing shares outstanding is 1M shares
• New Shares from $1M Round at $5M Pre-Money Valuation is 1M/$5M = 200,000 shares
• So total shares outstanding is 1M + 200,000 = 1.2M shares
• Therefore, non-discounted price per share is $6M/1.2M = $5
• Discounted Price Per Share = Non-Discounted Price x (100% – Discount %)
• = $5 x (100% – 20%) = $4

Step 3) Calculate SAFE Conversion Shares

• SAFE Investment Amount: $500K
• Conversion Price: $4
• SAFE Conversion Shares = SAFE Investment / Conversion Price
• = $500K / $4 = 125,000 shares

Step 4) Update Cap Table

• Pre-Money Shares Outstanding: 1M
• SAFE Conversion Shares: 125,000
• New Investor Shares: 200,000
• Post-Money Shares Outstanding = Pre-Money + SAFE Converted Shares + New Investor Shares
• = 1M + 125,000 + 200,000 = 1.325M

The post-money cap table would look as follows:

Shareholder	Pre-Money Shares	Post-Money Shares	Ownership %
Founders	1M	1M	75.5%
SAFE Investors	0	125,000	9.4%
New Investors	0	200,000	15.1%
Total	1M	1.325M	100%

Developing a Cap Table for Pre-Money SAFEs

Now let’s look at an example of constructing a cap table when a SAFE converts in a pre-money safe triggering event like an acquisition.

• Company XYZ previously raised a $500K SAFE with $3M valuation cap, 20% discount
• Company XYZ is now being acquired for $10M
• The SAFE will convert right before the acquisition closes

Step 1) Determine Conversion Price

• Valuation Cap: $3M
• Discount: 20%
• Non-Discounted Price Per Share = Valuation Cap / Fully Diluted Shares
• Let’s assume fully diluted shares outstanding is 1M
• Non-Discounted Price = $3M / 1M = $3
• Discounted Price = $3 x (100% – 20%) = $2.40

Step 2) Calculate SAFE Conversion Shares

• SAFE Investment Amount: $500K
• Conversion Price: $2.40
• SAFE Conversion Shares = Investment / Price
• = $500K / $2.40 = 208,333 shares

Step 3) Update Cap Table

• Pre-Money Shares: 1M
• SAFE Conversion Shares: 208,333
• Post-Money Shares = Pre-Money Shares + SAFE Converted Shares
• = 1M + 208,333 = 1,208,333

The pre-money cap table right before acquisition would be:

Shareholder	Pre-Money Shares	Post-Money Shares	Ownership %
Founders	1M	1M	82.7%
SAFE Investors	0	208,333	17.3%
Total	1M	1,208,333	100%

Key Takeaways

• Review SAFE terms like valuation cap, discount rate, and pro rata rights that impact conversion.
• For post-money SAFEs, determine conversion price based on the post-money valuation of the equity round.
• For pre-money SAFEs, use the valuation cap and discount rate to determine conversion price.
• Calculate conversion shares based on SAFE investment divided by conversion price.
• Update cap table with SAFE conversion shares and new investor shares.

Properly constructing your post-money and pre-money cap tables will ensure everyone understands their new ownership stakes once SAFEs convert. This allows the company to smoothly transition from convertible notes to priced equity rounds.

Conclusion

SAFE notes allow startups to quickly raise funds without setting a valuation. However, it is critical to understand how they convert and impact your cap table down the line. By reviewing the key SAFE terms and walking through cap table examples, startups can be prepared to manage SAFE conversions and subsequent priced rounds. With clear communication and organized cap table records, companies can effectively make the transition while aligning investor expectations.

FAQ

What is the difference between a pre-money and post-money SAFE?

The key difference between pre-money and post-money SAFEs is the timing of when the SAFE converts in relation to the valuation of the triggering event.

For a pre-money SAFE, the SAFE converts into equity immediately before the triggering event, such as a priced equity round or acquisition. The conversion price is based on the agreed upon pre-money valuation of the company, before taking into account the new investment from the triggering event. This means that the SAFE investor’s ownership stake is calculated based on the company’s valuation prior to the infusion of new capital.

In contrast, a post-money SAFE converts into equity immediately after the triggering event. The conversion price is determined using the post-money valuation, which includes the new investment amount. This means that the SAFE investor’s ownership percentage is diluted by the new equity issued in the triggering round.

Pre-money SAFEs are generally more favorable to investors because they lock in the conversion price based on the lower pre-money valuation. Post-money SAFEs provide a better deal for the company and the new equity investors, as the SAFE holders’ ownership is diluted by the new financing.

The choice between pre-money and post-money SAFEs depends on the negotiation between the company and the SAFE investors. It’s important for both sides to understand the implications of each type of SAFE on their potential ownership stake and return on investment.

How do SAFEs impact a company’s ability to raise future rounds of financing?

SAFEs can have both positive and negative impacts on a company’s ability to raise future rounds of financing.

On the positive side, SAFEs allow companies to quickly raise seed capital without the need for a priced equity round or a formal valuation. This can help startups get off the ground and achieve initial milestones to make them more attractive to future investors. SAFEs also signal that the company has successfully convinced early investors to back their vision, which can provide validation and momentum for future fundraising efforts.

However, having a large number of outstanding SAFEs on a company’s cap table can also create challenges for future financing rounds. As SAFEs convert into equity during subsequent rounds, they can significantly dilute the ownership stake of the founders and existing shareholders. This dilution can make it more difficult to attract new investors, who may be concerned about their potential return on investment.

Additionally, the terms of the SAFEs, such as the valuation cap and discount rate, can set a ceiling on the company’s valuation in future rounds. If the company has issued SAFEs with a low valuation cap, it may struggle to justify a much higher valuation to new investors, even if the company has made significant progress.

To mitigate these challenges, companies should be strategic about the number and terms of the SAFEs they issue. It’s important to strike a balance between raising sufficient seed capital and not creating an overly complex or dilutive cap table. Companies should also be transparent with future investors about the outstanding SAFEs and their potential impact on equity ownership.

In some cases, companies may need to renegotiate the terms of the SAFEs or buy out some SAFE holders to clean up the cap table before raising a new round of financing. Effective communication and planning can help manage the impact of SAFEs on future fundraising efforts.

What happens to SAFE holders if the company never has a triggering event?

If a company never experiences a triggering event, such as an equity financing round, acquisition, or IPO, the SAFE remains outstanding indefinitely. This means that the SAFE holder does not receive any equity in the company and does not have a clear path to realizing a return on their investment.

This scenario can be frustrating for SAFE holders, who may have expected the company to achieve a triggering event within a reasonable timeframe. Without a maturity date or other mechanism to force a conversion or repayment, the SAFE holder’s investment can be tied up indefinitely.

In some cases, the company may choose to voluntarily convert the SAFEs into equity, even without a triggering event. This can be done to clean up the cap table, reward early investors, or provide more clarity around equity ownership. However, the company is not obligated to take this step, and the terms of the voluntary conversion would need to be negotiated with the SAFE holders.

If the company winds up or dissolves without a triggering event, SAFE holders are typically treated as unsecured creditors. They would have a claim on any remaining assets of the company after all secured creditors and outstanding debts have been paid. However, in most cases, there are few assets left to distribute to unsecured creditors like SAFE holders.

To mitigate the risk of SAFEs never converting, some companies choose to include a maturity date in their SAFE agreements. This provides a deadline by which the company must either achieve a triggering event, voluntarily convert the SAFEs, or repay the investment amount. However, adding a maturity date can also create additional pressure on the company to raise future rounds of financing or pursue an exit within a specific timeframe.

Before investing in a SAFE, it’s important for investors to carefully consider the company’s prospects for achieving a triggering event and the potential risks of the investment never converting. Investors should also diversify their portfolio and not rely on a single SAFE investment to generate a return.

Can SAFE holders vote or have any control over company decisions?

No, SAFE holders generally do not have any voting rights or control over company decisions. SAFEs are a form of convertible security that do not represent an immediate equity stake in the company. As such, SAFE holders are not considered shareholders and do not have the same rights and privileges as common or preferred stockholders.

This lack of voting rights and control is one of the key differences between SAFEs and traditional convertible notes. Convertible notes are typically structured as debt instruments that can include provisions for voting rights or board seats for the noteholders. In contrast, SAFEs are designed to be simple, equity-focused instruments that do not grant investors any control over the company’s operations or decision-making.

The primary rights of SAFE holders are the right to convert their investment into equity upon a triggering event, and the right to receive certain information from the company, such as notices of future financing rounds or liquidity events. However, these rights do not extend to voting on key company decisions, such as the election of board members, approval of major transactions, or changes to the company’s bylaws.

In some cases, SAFE agreements may include provisions that grant SAFE holders the right to participate in future financing rounds on a pro rata basis, in order to maintain their ownership percentage. However, this participation right does not confer any additional voting power or control.

The lack of voting rights and control for SAFE holders is a trade-off for the simplicity and flexibility of the instrument. SAFEs are intended to provide a quick and efficient way for early-stage companies to raise seed capital, without the complexity and negotiation involved in a priced equity round or a convertible note with extensive investor protections.

For investors who are seeking more control and influence over the company’s direction, a SAFE may not be the most appropriate investment vehicle. These investors may prefer to invest in a priced equity round or negotiate for board seats or other control provisions as part of a convertible note or other investment instrument.

What is the difference between a valuation cap and a discount rate in a SAFE?

A valuation cap and a discount rate are two key terms that are often included in SAFE agreements to provide investors with some protection against dilution and to incentivize early investment.

A valuation cap sets a maximum price at which the SAFE will convert into equity, regardless of the actual valuation of the company at the time of the triggering event. For example, if a SAFE has a valuation cap of $5 million and the company raises a subsequent round of financing at a $10 million valuation, the SAFE will convert into equity at the $5 million valuation, rather than the higher $10 million valuation. This provides the SAFE investor with a larger ownership stake and potential return on investment than if they had invested at the higher valuation.

A discount rate, on the other hand, provides the SAFE investor with the right to convert their SAFE into equity at a discounted price relative to the price paid by investors in the triggering event. For example, if a SAFE has a discount rate of 20% and the triggering event is a financing round where new investors are paying $1 per share, the SAFE investor would be able to convert their SAFE into equity at a price of $0.80 per share. This rewards the SAFE investor for their early investment and provides them with a better price per share than later investors.

While both valuation caps and discount rates provide benefits to SAFE investors, they operate differently and can have different implications for the company and the investor. A valuation cap provides a clear maximum valuation at which the SAFE will convert, which can be helpful for investors in planning their expected return on investment. However, a valuation cap can also create challenges for the company in future fundraising rounds, as it may set an artificial ceiling on the company’s valuation and make it more difficult to justify a higher valuation to new investors.

A discount rate, on the other hand, does not set a specific valuation for the company, but rather provides the SAFE investor with a percentage discount to the price paid by new investors. This can be less restrictive for the company in terms of future valuation, but it also provides less certainty for the investor in terms of their potential ownership stake and return on investment.

Some SAFEs include both a valuation cap and a discount rate, with the investor having the right to convert their SAFE at the more favorable of the two terms. This provides the investor with the benefits of both provisions and can help to mitigate the risks of either a low valuation cap or a high valuation in the triggering event.

Ultimately, the choice between a valuation cap and a discount rate (or both) depends on the specific needs and preferences of the company and the investor. It’s important for both parties to carefully consider the implications of these terms and to negotiate a SAFE agreement that balances the interests of both the company and the investor.

How do SAFEs interact with a company’s existing stock option plan?

SAFEs can have a significant impact on a company’s existing stock option plan and the overall equity structure of the company. When SAFEs convert into equity during a triggering event, such as a financing round or acquisition, the newly issued shares can dilute the ownership percentage of existing shareholders, including employees and other service providers who hold stock options.

To mitigate this dilution and ensure that there are sufficient shares available for future equity grants, companies often include a provision in their SAFE agreements that requires the company to increase the size of its stock option plan upon the conversion of the SAFEs. This is known as an “option pool expansion” or “option pool top-up” provision.

Under this provision, the company agrees to increase the number of shares reserved for issuance under its stock option plan by a certain percentage or number of shares, based on the amount of equity issued upon the conversion of the SAFEs. For example, the SAFE agreement may require the company to increase its option pool by 10% of the total number of shares issued in the triggering event.

The purpose of this option pool expansion is to ensure that the company has sufficient shares available to continue granting equity incentives to employees and other service providers, even after the dilution caused by the SAFE conversion. This can be important for attracting and retaining key talent, as well as aligning the interests of employees with those of the company and its investors.

However, the option pool expansion provision can also have implications for the company’s valuation and the ownership stake of existing shareholders. When the company increases its option pool, the newly reserved shares are typically included in the company’s fully diluted share count, which can lower the effective price per share and dilute the ownership of existing shareholders.

To account for this dilution, companies often negotiate with SAFE investors to determine the appropriate size of the option pool expansion and to ensure that it is fair to all parties. In some cases, the company may also choose to grant additional equity awards to existing employees and service providers to offset the dilution caused by the SAFE conversion and option pool expansion.

It’s important for companies to carefully consider the impact of SAFEs on their existing stock option plan and to plan accordingly. This may involve modeling different scenarios for SAFE conversion and option pool expansion, communicating with employees and other stakeholders about the potential impact on their equity ownership, and working with legal and financial advisors to structure the SAFE agreements and equity incentive plans in a way that balances the needs of the company, its employees, and its investors.

What is the purpose of a Most Favored Nation (MFN) provision in a SAFE?

A Most Favored Nation (MFN) provision is a clause that is sometimes included in SAFE agreements to protect early investors in the event that the company issues SAFEs with more favorable terms to subsequent investors.

Under an MFN provision, if the company issues SAFEs to new investors with terms that are more advantageous than those given to the original SAFE holders, the company is required to extend those same favorable terms to the original SAFE holders as well. This ensures that early investors are not disadvantaged by the company’s future fundraising efforts and that they receive the same benefits as later investors.

The specific terms that may be covered by an MFN provision can vary depending on the specific language of the SAFE agreement, but they typically include the valuation cap, discount rate, and any other key economic terms. For example, if a company issues a SAFE with a valuation cap of $5 million to an early investor, and later issues a SAFE with a valuation cap of $4 million to a new investor, the MFN provision would require the company to adjust the valuation cap for the early investor to match the $4 million cap given to the new investor.

The purpose of an MFN provision is to provide early investors with some protection against being diluted or disadvantaged by the company’s future fundraising efforts. By ensuring that early investors receive the same favorable terms as later investors, an MFN provision can help to incentivize early investment and provide a sense of fairness and equity among different groups of investors.

However, MFN provisions can also create some challenges and complications for companies. If a company issues SAFEs with different terms to different investors over time, it can be difficult to keep track of all the various provisions and ensure that all investors are being treated fairly under the MFN clause. This can lead to disputes or legal challenges if investors feel that they have not received the benefits they are entitled to under the MFN provision.

Additionally, MFN provisions can sometimes create a disincentive for companies to offer more favorable terms to later investors, even if doing so would be beneficial for the company’s growth and development. If a company knows that it will have to extend those same favorable terms to all of its existing SAFE holders, it may be reluctant to negotiate better terms with new investors, even if those terms would help the company to raise more capital or achieve its strategic objectives.

To address these challenges, some companies choose to include limitations or carve-outs in their MFN provisions, such as excluding certain types of investors or capping the total amount of additional investment that is subject to the MFN clause. Others may choose to negotiate MFN provisions on a case-by-case basis, rather than including them as a standard term in all of their SAFE agreements.

Ultimately, the decision to include an MFN provision in a SAFE agreement depends on the specific needs and circumstances of the company and its investors. While an MFN clause can provide important protections for early investors, it’s important for companies to carefully consider the potential benefits and drawbacks of including such a provision and to work with experienced legal and financial advisors to structure their SAFE agreements in a way that balances the interests of all parties.

How do SAFEs differ from traditional convertible debt instruments?

SAFEs (Simple Agreement for Future Equity) and traditional convertible debt instruments, such as convertible notes, are both commonly used by early-stage companies to raise seed capital. While they share some similarities in terms of converting into equity at a future date, there are also some key differences between SAFEs and convertible debt.

One of the main differences is that convertible debt instruments are structured as loans, with the investor providing capital to the company in exchange for a promissory note that can be converted into equity at a later date. The note typically includes an interest rate and a maturity date, at which point the company must either repay the loan or convert it into equity.

In contrast, SAFEs are not structured as loans, but rather as a type of warrant or option to purchase equity in the future. SAFEs do not have an interest rate or a maturity date, and the investor’s capital is not treated as a loan to the company. Instead, the SAFE investor receives the right to convert their investment into equity at a future trigger event, such as a financing round or acquisition.

Another key difference is that convertible debt instruments often include more extensive investor protections and control rights than SAFEs. For example, convertible notes may include provisions for board seats, voting rights, or information rights for the noteholders. They may also include covenants that restrict the company’s ability to take certain actions without the consent of the noteholders, such as incurring additional debt or selling assets.

SAFEs, on the other hand, are designed to be simple and streamlined agreements that do not include many of these additional investor protections. SAFEs typically do not grant investors any control rights or board seats, and they do not include the same types of restrictive covenants as convertible notes.

The treatment of SAFEs and convertible debt in the event of a bankruptcy or liquidation can also differ. In a bankruptcy or liquidation, convertible debt holders are typically treated as creditors of the company, with a claim on the company’s assets that is senior to that of equity holders. SAFE holders, on the other hand, are typically treated as unsecured creditors, with a claim on the company’s assets that is subordinate to that of other creditors.

Another difference is the way in which SAFEs and convertible debt are converted into equity. Convertible notes typically convert into equity at a discount to the price per share of the triggering event, with the discount rate serving as a reward for the early investment. SAFEs, on the other hand, typically convert at either a discount rate or a valuation cap, whichever results in a lower price per share for the SAFE investor.

The choice between using a SAFE or a convertible note ultimately depends on the specific needs and circumstances of the company and its investors. SAFEs can be a good option for companies that want to raise seed capital quickly and efficiently, without the complexity and legal costs associated with convertible notes. They can also be attractive to investors who are more focused on the potential upside of the investment, rather than the downside protection and control rights that come with convertible debt.

However, convertible notes may be a better choice for companies that need more extensive investor protections or that are looking to raise larger amounts of capital. They may also be preferred by investors who are more risk-averse and who want the additional security and control that comes with a debt instrument.

Ultimately, both SAFEs and convertible notes can be effective tools for early-stage fundraising, and the choice between them depends on a careful consideration of the company’s and investors’ goals, risk tolerance, and legal and financial needs.

What happens to SAFEs in the event of a down round?

A “down round” refers to a situation where a company raises a new round of financing at a lower valuation than its previous round. This can occur for a variety of reasons, such as a change in market conditions, a shift in the company’s business model, or a failure to meet growth or revenue targets.

In the event of a down round, SAFEs can be particularly vulnerable to dilution, as the lower valuation can result in a significantly higher conversion price for the SAFE investor. This means that the SAFE investor may end up with a much smaller ownership stake in the company than they had originally anticipated.

The specific impact of a down round on SAFE holders depends on the terms of the SAFE agreement, particularly the valuation cap and discount rate. If the SAFE has a high valuation cap, the down round may not have a significant impact on the SAFE holder’s ownership stake, as the conversion price will still be based on the valuation cap rather than the new, lower valuation.

However, if the SAFE has a low valuation cap or no cap at all, the SAFE holder may be more exposed to dilution in a down round. In this case, the conversion price of the SAFE will be based on the new, lower valuation, which can result in the SAFE holder receiving a much smaller number of shares than they would have at a higher valuation.

One way that some SAFE agreements try to mitigate the impact of a down round is through the inclusion of an “anti-dilution” provision. This provision typically adjusts the conversion price of the SAFE in the event of a down round, so that the SAFE holder receives more shares than they would have otherwise. However, the specific terms of an anti-dilution provision can vary widely, and not all SAFEs include such a provision.

Another potential impact of a down round on SAFE holders is the risk of the company running out of money before it can achieve a successful exit or raise additional funding. In a down round, the company may need to raise more capital than originally anticipated in order to continue operations, which can further dilute the ownership stakes of existing shareholders, including SAFE holders.

To mitigate the risks of a down round, SAFE investors should carefully review the terms of the SAFE agreement and consider the potential impact of different valuation scenarios on their ownership stake. They should also conduct thorough due diligence on the company and its business model, to assess the likelihood of a down round occurring and to evaluate the company’s ability to weather such an event.

Companies, on the other hand, should be transparent with their SAFE investors about the potential risks and uncertainties associated with their business, and should work to maintain open lines of communication and alignment with their investors throughout the fundraising process. They may also consider alternative fundraising strategies, such as raising a smaller amount of capital at a higher valuation, or pursuing non-dilutive funding sources such as grants or revenue-based financing.

Overall, while SAFEs can be a useful tool for early-stage fundraising, they are not without risks, particularly in the event of a down round. Both companies and investors should carefully consider these risks and work to structure their SAFE agreements in a way that balances the needs and interests of all parties involved.

What are the tax implications of SAFEs for investors and the company?

The tax implications of SAFEs can be complex and can vary depending on the specific terms of the SAFE agreement and the tax status of the investors and the company. It’s important for both investors and companies to consult with qualified tax professionals to understand the potential tax consequences of SAFEs and to structure their agreements in a way that minimizes tax liabilities.

For investors, the tax treatment of SAFEs depends on whether the SAFE is classified as equity or debt for tax purposes. If the SAFE is classified as equity, the investor may be required to pay taxes on any gains realized upon the conversion of the SAFE into stock, based on the difference between the fair market value of the stock received and the amount paid for the SAFE. If the SAFE is classified as debt, the investor may be required to pay taxes on any interest earned on the SAFE, although SAFEs typically do not include an interest rate.

One potential tax benefit for SAFE investors is the ability to claim a loss on their investment if the company fails or the SAFE does not convert into equity. However, the ability to claim such a loss may be limited by the specific terms of the SAFE agreement and the investor’s individual tax situation.

For companies, the tax treatment of SAFEs can also be complex. In general, the issuance of a SAFE is not a taxable event for the company, as the company has not yet received any cash proceeds from the investor. However, when the SAFE converts into equity, the company may be required to recognize taxable income based on the fair market value of the stock issued to the SAFE holder.

One potential tax benefit for companies issuing SAFEs is the ability to defer the recognition of taxable income until the SAFE converts into equity. This can help the company to manage its cash flow and minimize its tax liabilities in the early stages of its development.

However, companies should also be aware of the potential tax risks associated with SAFEs, particularly if the company undergoes a change in ownership or experiences a down round. In these situations, the company may be required to recognize taxable income based on the difference between the fair market value of the stock issued to SAFE holders and the amount paid for the SAFEs, even if the company has not yet received any cash proceeds from the SAFEs.

To minimize the tax risks associated with SAFEs, companies should work with experienced tax professionals to structure their SAFE agreements in a way that complies with applicable tax laws and regulations. They should also maintain accurate and up-to-date records of all SAFE issuances and conversions, and should communicate regularly with their investors to ensure that everyone is on the same page regarding the tax implications of the SAFEs.

Investors, on the other hand, should carefully review the tax implications of any SAFE investment and should consult with their own tax advisors to understand how the investment may impact their individual tax situation. They should also keep accurate records of their SAFE investments and should report any gains or losses on their tax returns as required by law.

Overall, while SAFEs can be a useful tool for early-stage fundraising, they can also have significant tax implications for both investors and companies. By working with experienced professionals and structuring their agreements carefully, however, both parties can minimize their tax risks and maximize the benefits of this innovative investment vehicle.

How do SAFEs impact a company’s ability to attract venture capital investment?

SAFEs can have both positive and negative impacts on a company’s ability to attract venture capital investment, depending on the specific terms of the SAFEs and the stage of the company’s development.

On the positive side, SAFEs can be a useful tool for companies to raise seed capital quickly and efficiently, without the need for a formal valuation or the legal and administrative costs associated with a traditional equity financing round. This can help companies to build momentum and achieve key milestones that can make them more attractive to venture capital investors down the line.

Additionally, SAFEs can serve as a signal to venture capital investors that the company has a track record of successfully raising capital and has a network of supportive early-stage investors. This can help to validate the company’s business model and increase its credibility with potential investors.

However, SAFEs can also create some challenges for companies seeking venture capital investment, particularly if the terms of the SAFEs are not well-aligned with the interests of venture capital investors.

One potential issue is that SAFEs can create a complex and potentially dilutive cap table for the company, particularly if the company has issued multiple rounds of SAFEs with different valuation caps and discount rates. This can make it difficult for venture capital investors to understand their potential ownership stake in the company and can create concerns about the company’s ability to raise additional capital in the future.

Another potential challenge is that SAFEs may not provide venture capital investors with the same level of control and governance rights as traditional preferred stock. Venture capital investors typically require a certain level of control over the company’s decision-making and may be reluctant to invest in a company that has a significant number of SAFE holders with potentially conflicting interests.

Additionally, if the company has issued SAFEs with high valuation caps or low discount rates, venture capital investors may be concerned about the potential dilution of their ownership stake and may require the company to renegotiate the terms of the SAFEs as a condition of their investment.

To mitigate these challenges and attract venture capital investment, companies should be strategic about the terms of their SAFE agreements and should work to align the interests of their SAFE holders with those of potential venture capital investors. This may involve setting reasonable valuation caps and discount rates, limiting the number of SAFE rounds issued, and communicating regularly with SAFE holders to ensure that everyone is on the same page regarding the company’s fundraising plans and goals.

Companies should also be transparent with potential venture capital investors about the terms of their outstanding SAFEs and should be prepared to address any concerns or questions that investors may have about the impact of the SAFEs on the company’s cap table and future fundraising prospects.

Venture capital investors, on the other hand, should carefully review the terms of a company’s outstanding SAFEs and should assess the potential impact of the SAFEs on their investment thesis and ownership stake. They may also want to consider negotiating specific terms or conditions as part of their investment, such as the ability to convert their preferred stock into common stock at a later date or the right to participate in future funding rounds.

Overall, while SAFEs can be a useful tool for early-stage fundraising, they can also create some challenges for companies seeking venture capital investment. By being strategic about the terms of their SAFE agreements and communicating openly and transparently with potential investors, however, companies can increase their chances of attracting the capital they need to grow and succeed.

How do SAFEs impact a company’s valuation in future rounds of financing?

SAFEs can have a significant impact on a company’s valuation in future rounds of financing, depending on the specific terms of the SAFEs and the timing and size of the future rounds.

One of the key factors that can impact a company’s valuation in future rounds is the valuation cap set in the SAFEs. The valuation cap sets a maximum price at which the SAFEs will convert into equity, regardless of the actual valuation of the company at the time of conversion. If the company raises a future round of financing at a valuation higher than the valuation cap, the SAFE holders will receive a greater number of shares than they would have otherwise, effectively giving them a larger ownership stake in the company.

This can create a challenge for the company in future rounds, as it may need to issue a larger number of shares to new investors in order to raise the desired amount of capital, which can dilute the ownership stakes of existing shareholders. Additionally, if the valuation cap is set too low, it may limit the company’s ability to raise capital at a higher valuation in the future, as investors may be reluctant to invest at a valuation that is significantly higher than the valuation cap.

Another factor that can impact a company’s valuation in future rounds is the discount rate set in the SAFEs. The discount rate provides SAFE holders with the right to convert their SAFEs into equity at a discounted price relative to the price paid by new investors in the future round. This can also dilute the ownership stakes of new investors and may make it more difficult for the company to raise capital at a higher valuation.

To mitigate the impact of SAFEs on future valuations, companies should be strategic about the terms of their SAFE agreements and should set reasonable valuation caps and discount rates that are aligned with their long-term fundraising goals. They should also be transparent with potential investors about the terms of their outstanding SAFEs and should be prepared to address any concerns or questions that investors may have about the impact of the SAFEs on the company’s valuation and ownership structure.

Companies should also consider the timing and size of their future funding rounds carefully, and should work to build a strong business case and financial plan that can justify a higher valuation and attract investors who are aligned with their long-term vision and goals.

Investors, on the other hand, should carefully review the terms of a company’s outstanding SAFEs and should assess the potential impact of the SAFEs on the company’s valuation and their own ownership stake. They may want to consider negotiating specific terms or conditions as part of their investment, such as a higher valuation cap or a lower discount rate, in order to protect their interests and ensure that they are getting a fair deal.

Overall, while SAFEs can be a useful tool for early-stage fundraising, they can also have a significant impact on a company’s valuation in future rounds of financing. By being strategic about the terms of their SAFE agreements and communicating openly and transparently with potential investors, however, companies can increase their chances of raising capital at a fair valuation and building a strong and sustainable business over the long term.

What are some common mistakes that companies make when issuing SAFEs?

While SAFEs can be a useful tool for early-stage fundraising, there are also some common mistakes that companies can make when issuing SAFEs that can create challenges down the line. Here are a few examples:

1. Setting the valuation cap too high or too low: One of the most important terms in a SAFE is the valuation cap, which sets the maximum price at which the SAFE will convert into equity. If the valuation cap is set too high, it may limit the company’s ability to raise capital at a reasonable valuation in the future. On the other hand, if the valuation cap is set too low, it may give SAFE holders an overly large ownership stake in the company and dilute the ownership of future investors.
2. Not communicating clearly with SAFE holders: Companies should be transparent and communicative with their SAFE holders throughout the fundraising process. This includes providing regular updates on the company’s progress and financial performance, as well as clearly explaining the terms of the SAFE and how it may impact the SAFE holder’s ownership stake in the company.
3. Issuing too many rounds of SAFEs: While issuing multiple rounds of SAFEs can be a useful way to raise capital over time, it can also create a complex and potentially dilutive cap table for the company. This can make it difficult for the company to attract future investors and may limit its ability to raise capital at a reasonable valuation.
4. Not considering the impact of SAFEs on future rounds: Companies should carefully consider the potential impact of their outstanding SAFEs on future rounds of financing, including the potential dilution of existing shareholders and the challenges of justifying a higher valuation to new investors.
5. Not seeking legal and financial advice: Issuing SAFEs can be a complex process with significant legal and financial implications. Companies should work with experienced legal and financial advisors to ensure that their SAFE agreements are properly structured and comply with all relevant laws and regulations.
6. Not having a clear plan for using the funds: Before issuing SAFEs, companies should have a clear plan for how they will use the funds raised to achieve their business goals and milestones. This can help to build trust with SAFE holders and demonstrate the company’s commitment to building a successful business.
7. Not considering alternative funding options: While SAFEs can be a useful tool for early-stage fundraising, they may not be the best option for every company or situation. Companies should carefully consider their funding needs and explore alternative options, such as traditional equity financing or revenue-based financing, to determine the best path forward.

To avoid these mistakes, companies should take a strategic and thoughtful approach to issuing SAFEs, and should work with experienced advisors to ensure that their agreements are properly structured and aligned with their long-term business goals. By being transparent, communicative, and forward-thinking, companies can maximize the benefits of SAFEs while minimizing the potential risks and challenges.

How can companies and investors negotiate SAFE terms to balance their interests?

Negotiating the terms of a SAFE can be a complex process, as companies and investors may have different priorities and objectives. However, by approaching the negotiation process in a collaborative and transparent manner, both parties can work to find a balance that meets their respective needs and interests. Here are a few key strategies for negotiating SAFE terms:

1. Understand each party’s goals and priorities: Before entering into a negotiation, both the company and the investor should take the time to clearly articulate their goals and priorities for the SAFE. This may include the amount of capital the company is seeking to raise, the investor’s target ownership stake, and any specific terms or conditions that are important to either party.
2. Be transparent about the company’s financial situation: The company should be transparent with potential investors about its current financial situation, including its cash burn rate, revenue projections, and any outstanding debt or other obligations. This can help investors to better understand the company’s funding needs and risk profile, and can facilitate a more productive negotiation process.
3. Consider the long-term impact of the terms: When negotiating the terms of a SAFE, both parties should consider the potential long-term impact of the agreement on the company’s future fundraising prospects and ownership structure. This may involve discussing the valuation cap, discount rate, and any other key terms that could impact the company’s ability to raise capital in the future.
4. Be willing to compromise: Negotiating a SAFE is often a give-and-take process, and both parties should be willing to make reasonable compromises in order to reach an agreement that works for everyone. This may involve adjusting the valuation cap, discount rate, or other terms in order to find a middle ground that balances the interests of both the company and the investor.
5. Consider alternative structures: If the standard SAFE structure does not seem to be a good fit for the company or the investor, both parties should be open to considering alternative structures that may better meet their needs. For example, a convertible note with a maturity date and interest rate may be a better option for some investors, while a revenue-based financing agreement may be more appropriate for some companies.
6. Seek legal and financial advice: Negotiating a SAFE can be a complex process with significant legal and financial implications. Both parties should seek the advice of experienced legal and financial professionals to ensure that the terms of the agreement are fair, reasonable, and legally enforceable.
7. Document the agreement clearly: Once the terms of the SAFE have been negotiated, it is important to document the agreement clearly and comprehensively in writing. This should include all of the key terms and conditions, as well as any contingencies or obligations that either party has agreed to.
8. Communicate regularly: After the SAFE has been issued, the company and the investor should maintain regular communication to ensure that both parties are aligned and informed about the company’s progress and any changes to its financial situation or business strategy.

By following these strategies and approaching the negotiation process in a collaborative and transparent manner, companies and investors can work together to structure a SAFE that meets their respective needs and interests, while also setting the stage for a successful long-term partnership. Ultimately, the key to a successful SAFE negotiation is to focus on finding a mutually beneficial solution that allows the company to raise the capital it needs to grow and succeed, while also providing the investor with a fair and attractive return on their investment.

What are some best practices for managing SAFE cap tables and investor relations?

Managing SAFE cap tables and investor relations can be a complex and time-consuming process, but it is essential for companies that have issued SAFEs to maintain accurate records and communicate effectively with their investors. Here are some best practices for managing SAFE cap tables and investor relations:

1. Keep accurate and up-to-date records: Companies should maintain accurate and up-to-date records of all SAFE issuances, including the date of issuance, the name and contact information of the investor, the amount invested, and the key terms of the SAFE (such as the valuation cap and discount rate). This information should be regularly reviewed and updated to ensure that it is accurate and complete.
2. Use cap table management software: Companies may want to consider using specialized cap table management software to help track and manage their SAFE issuances and other equity instruments. These tools can help to automate many of the administrative tasks associated with cap table management, such as tracking ownership percentages, calculating dilution, and generating reports.
3. Communicate regularly with investors: Companies should communicate regularly with their SAFE investors to keep them informed about the company’s progress, financial performance, and any changes to its business strategy or funding plans. This can include providing regular updates via email, holding investor calls or meetings, and sharing key financial and operational metrics.
4. Be transparent about the impact of future funding rounds: Companies should be transparent with their SAFE investors about the potential impact of future funding rounds on their ownership stake and the value of their investment. This may involve providing regular updates on the company’s fundraising plans and the potential dilution that SAFE holders may experience as a result of future rounds.
5. Offer opportunities for follow-on investment: Companies may want to consider offering their SAFE investors the opportunity to participate in future funding rounds on a pro rata basis, in order to help them maintain their ownership stake and potentially increase the value of their investment over time.
6. Seek feedback and input from investors: Companies should actively seek feedback and input from their SAFE investors, and should be open to incorporating their ideas and suggestions into the company’s business strategy and decision-making processes. This can help to build trust and alignment between the company and its investors, and can ultimately lead to better outcomes for all parties.
7. Have a clear plan for SAFE conversion: Companies should have a clear plan in place for how and when their outstanding SAFEs will convert into equity, and should communicate this plan clearly to their investors. This may involve setting specific milestones or triggering events that will cause the SAFEs to convert, or establishing a timeline for when the company expects to raise its next round of funding.
8. Work with experienced advisors: Managing SAFE cap tables and investor relations can be a complex and technical process, and companies may want to consider working with experienced legal, financial, and accounting advisors to ensure that they are following best practices and complying with all relevant laws and regulations.

By following these best practices and maintaining open and transparent communication with their SAFE investors, companies can build strong and productive relationships with their investors, while also ensuring that their cap table remains accurate and up-to-date over time. Ultimately, effective SAFE cap table management and investor relations can help to position companies for long-term success and growth, while also providing investors with the information and support they need to make informed decisions about their investments.

What happens if the valuation cap is exceeded in an equity financing?

If the pre-money valuation established in an equity financing exceeds the valuation cap set in the SAFE, the SAFE holders are protected by converting at the valuation cap, rather than the higher priced round.

For example, if a SAFE has a $5 million valuation cap and the company completes an equity financing at an $8 million pre-money valuation, the SAFE holders will still convert their investment at the $5 million cap. If they converted at the $8 million pre-money valuation without a cap, it would significantly dilute the original SAFE holders.

By converting at the valuation cap price, the SAFE holders receive the benefit of converting at a lower price per share based on the cap, while the equity investors pay the higher pre-money valuation they negotiated. This dynamic aligns incentives by allowing both the SAFE holders and new equity investors to receive favorable conversion terms.

How is the conversion price determined if no valuation cap exists?

If a SAFE does not include a valuation cap, the conversion price is determined by the discounted price paid by investors in the equity financing round that triggers the conversion.

For example, if the SAFE has a 20% discount and the triggering equity round has a $5 million pre-money valuation with investors paying $1 per share, the non-discounted price per share would be $5 million divided by the fully diluted number of shares outstanding.

If fully diluted shares outstanding is 5 million shares, the non-discounted price is $5 million/5 million shares = $1 per share. The SAFE conversion price would then be $1 * (100% – 20% discount) = $0.80 per share.

By tying the conversion price to the equity round valuation without a cap, the company avoids capping the upside for equity investors if they are willing to invest at higher valuations. The SAFE holders still receive the same discount rate to mitigate potential dilution.

Can SAFE holders lose their pro rata rights?

Yes, SAFE holders can lose their pro rata rights if they do not affirmatively elect to exercise their rights to purchase a pro rata portion of the shares issued in subsequent equity financing rounds.

The pro rata rights give SAFE holders the ability to purchase additional shares in future equity rounds to maintain their ownership percentage and avoid dilution. However, most SAFE agreements require SAFE holders to provide written notice that they intend to exercise these rights upon receiving notification of a new equity financing.

If a SAFE holder fails to provide this notice in the required timeframe (such as 15 or 30 days), the company may conclude that the SAFE holder has elected not to exercise their pro rata rights. This could significantly dilute their ownership stake since they failed to participate in the new equity round alongside other existing shareholders.

Who makes the decision on whether a SAFE converts pre-money or post-money?

The company’s board of directors and a majority of the SAFE holders must agree on whether conversion will occur pre-money or post-money upon a triggering event.

Often the terms of the SAFE will dictate the default conversion timing. For an equity financing, SAFEs typically convert post-money. For an acquisition, conversion often occurs pre-money. However, the board and a majority of SAFE holders can agree to modify the timing for each specific triggering event as needed.

Having a flexible approach outlined in the SAFE documents allows the company and investors to determine the optimal timing for conversion based on the particular deal terms and structure, while protecting SAFE holders by requiring their consent.

How do you determine the fully diluted shares outstanding for pre-money conversion?

To determine the accurate fully diluted shares outstanding for a pre-money SAFE conversion, the company should include not only all common stock issued and outstanding, but also the number of shares subject to issued stock options and any shares reserved for future award under a stock option plan.

Issued stock options that are vested and exercisable should be included in the fully diluted share count, as holders could exercise their options before the conversion event like an acquisition. The option plan share reserve reflects shares that could still be granted under the plan at the board’s discretion.

By taking into account the complete capitalization, including approved option pools, the pre-money conversion price reflects the fair market value per share and prevents dilution of SAFE holders. This provides for equitable conversion terms and appropriate investor protections.

What approval is required to issue SAFE conversion shares?

When SAFE notes are converted, the company’s board of directors must approve the issuance of any new shares to the SAFE holders per the conversion terms. This requires proper written board consent authorizing the new issuance and any resulting increase in the number of shares outstanding.

Additionally, if the SAFE conversion shares exceed the current share reserve under the company’s equity incentive plan, the plan must be amended to increase the reserve pool. This amendment would need board approval and shareholder consent before the conversion shares can be issued. Taking these formal steps ensures the SAFE conversions comply with corporate governance requirements and are properly documented.

What are the pros and cons of SAFEs compared to convertible notes?

Pros

• Faster fundraising due to standardized docs
• Lower legal fees using simple template vs. negotiated convertible note
• Investor friendly terms like valuation caps favor SAFE holders
• Avoid setting valuation before future priced rounds

Cons

• Lack of maturity date means investment stays outstanding indefinitely
• Fewer investor protections compared to full convertible note agreements
• Interest rates not included – no compensation for duration of investment
• Conversion timing uncertainty can complicate planning for priced rounds

Overall, SAFEs provide more flexibility and lower friction for early fundraising, but convertible notes offer more control and investor protections. The choice depends on the company’s needs and context.

How can companies modify SAFE terms to be more balanced?

Some ways companies can modify SAFE terms to create more balanced rights include:

• Adding a maturity date to eventually force conversion or repayment
• Removing or limiting the valuation cap to avoid artificial ceiling
• Including a floor on the valuation cap to protect against extremely low conversions
• Making the discount rate variable instead of fixed based on time or milestones
• Requiring investor consent for key company actions prior to conversion
• Granting SAFE holders access rights to company financials and other information
• Including a buyback provision to allow repurchasing SAFEs at the company’s discretion

The optimal modifications depend on the specific company, investors, and fundraising objectives. Both sides should thoughtfully negotiate reasonable terms.

What steps should companies take to prepare for conversion of outstanding SAFEs?

To prepare for conversion, companies should:

• Maintain detailed cap table records tracking all SAFEs and their terms
• Model potential impact on equity ownership under different scenarios
• Determine policies on pro rata participation rights for SAFE holders
• Review any required consents from existing investors for new issuances
• Assess implications on stock option plan share reserve requirements
• Develop balanced proposal for conversion timing (pre vs. post)
• Initiate discussions on conversion mechanics with major SAFE holders early
• Get board approval and stockholder consent for implementation

Proactive preparation and clear communication allow for organized SAFE conversions that protect company interests and align all stakeholder expectations.

What types of triggering events can cause a SAFE to convert?

The most common SAFE triggering events that lead to conversion are:

• Equity financing – company raises a priced round of preferred stock
• Liquidity event – company is acquired or completes an IPO
• Change of control – majority stake or controlling interest is sold
• Maturity date – automatic conversion if a maturity date is added
• Termination event – conversion triggered by severe events like bankruptcy

How can companies incorporate vesting schedules with SAFE conversions?

Companies can implement vesting for SAFE conversion shares to motivate long-term commitment from founders, employees and service providers holding SAFEs. Typical vesting would be 3-4 years with a 1 year cliff.

What happens to SAFEs if a company is dissolved?

If a company dissolves before a conversion event, SAFE holders are treated as general unsecured creditors and have claims on any remaining assets based on the outstanding SAFE amounts. However, creditors and stockholders often recover very little after liquidation.

Do all SAFE holders have to convert at the same time?

No, each SAFE holder can decide independently whether to convert their SAFE under the triggering event terms. However, conversion at different times can complicate cap table management. Most companies coordinate simultaneous conversion.

How can companies buy back issued SAFEs?

Companies can add a buyback provision when issuing SAFEs to retain flexibility to repurchase SAFEs from holders at a predetermined price or formula prior to conversion. This allows removing SAFEs from the cap table.