One of most recurring fundraising questions raised by our early-stage clients is about the difference between Simple Agreements for Future Equity (SAFEs) and priced equity financings (customarily issued in the form of Preferred Stock), and which they should choose for their fundraise. There are certain advantages and disadvantages with respect to each avenue of fundraising:

A Glimpse of SAFEs

SAFEs were an instrument created by Y Combinator as a more cost-efficient and easier route for early-stage companies to raise capital.  It is important to understand that SAFEs are not debt because there is no maturity date or interest incurring on the SAFEs.  SAFEs were actually created as an alternative to Convertible Notes (a form of debt) for early-stage founders because, philosophically, the venture community felt like early-stage investments should be viewed as equity investments even if the company isn’t truly ready for a priced round. Therefore, SAFEs are meant to serve as more favorable ways of raising capital for founders, who often do not have the luxury of cash for interest payments or facing the pressure of mandatory payment upon maturity date.

For some additional context, and as mentioned above, another key way that startups raise funds is by selling preferred stock.  In most instances, preferred stock is (as the name suggests) preferrable to common stock as it typically entails priority payout in an exit event and special voting privileges and protections when it comes to critical company actions and governance.  The degree to which preferred stock investors enjoy these extra benefits is hotly negotiated on a round-by-round basis, thus requiring a sizeable investment of time and money on the company side to carry out a preferred financing.  Most early-stage startups need to focus their attention and resources on developing an MVP or building out a stellar team rather than on negotiating a preferred financing fair to all parties involved.  Enter the SAFE, which allows startups and their earliest investors to kick that preferred financing can down the road to a time better suited to determine a company’s tangible and intangible value.

The most typical three terms that are requested and/or negotiated in a SAFE financing are the following:

(i)    Valuation Cap: The valuation cap stands for the maximum dollar value of the company at which the SAFE converts into shares of Preferred Stock for the SAFE investors in your next financing round. To illustrate, if the company raises money at a $10 million valuation at its next financing round whereas the SAFE holder had been given a $7 million valuation cap, the SAFE holder’s investment amount would convert into equity as if the company was valued at $7 million. That would mean a lower price per share for the SAFE investors and therefore more shares per dollar invested as a result of the SAFE converting at that lower price per share.

(ii)   Discount: Having a discount means that the SAFE would convert into equity with X% (the discount amount) less of a price per share than the price per share paid by the new money investors in the priced equity financing round. Market standard for such discount rate for a company that has never done a priced round is a 20% discount, and the discount is often in addition to also having a valuation cap (in which case the investors get the lower price of the discounted price OR the valuation cap price).  Otherwise, for a bridge financing SAFE round after a company has done a priced equity round, the discount can typically range between 10% to 20%.

(iii) Most Favored Nation (MFN): The MFN is a provision that you will find in some SAFEs (whether or not involving valuation cap and/or discount), and it means that the holder of such SAFE will benefit from any more favorable terms (such as lower valuation caps or bigger discounts) provided to subsequent SAFE investors.  It’s important to note that an MFN only applies while the SAFE is outstanding – in other words, when the company hopefully has an equity financing and its outstanding SAFEs at that time convert, those outstanding SAFEs terminate and no longer have any future rights, including the MFN right.  We like to use an MFN for the earliest friends and family financing rounds, where the investors aren’t experienced in setting a valuation cap or other SAFE terms but want to make an investment to get some initial cash into the company.

Should we use SAFEs?

For early-stage financings, the answer is often yes. SAFEs simplify and accelerate capital injections into startups. SAFEs are more company-friendly than convertible notes and, compared to priced rounds, they save time and money for early-stage companies because, by design, SAFEs are meant to be simple documents and not negotiated or revised extensively. (Y Combinator has template forms of various SAFEs that companies can easily use – though note that there are one or two tweaks that we at Bowery Legal make to protect founders against unnecessary dilution!) In addition, SAFEs represent the perfect compromise to early-stage fundraising, as they defer the required time, expense and thought investment of a priced equity round to a later time while still giving the company’s earliest supporters the due benefit of being the first money through the door.

Just make sure when using a SAFE that you put real thought into how you set your valuation cap, and how much money you decide to raise in the round / at that valuation cap. Otherwise, if you set the cap too low or raise more than you should, the SAFE can result in significant discount to the new money price per share in the equity financing and/or significant dilution to the founders.

When should we do an equity financing?

As with all things, it depends.  It depends on the financial needs of the company, both now and going forward.  It depends on the size of the round and the investors you are talking to.  And it depends on how much of your company you will need to sell to bring in the funds to elevate it to that next level.  If you are raising an amount in the millions of dollars and you’re working with a lead investor that is used to the process of (a) setting a pre-money valuation on early-stage companies and (b) leading a financing round where they are expected to negotiate and set the terms of the first round of preferred equity (which will be a precedent for all future equity financing rounds going forward), then you might be in a good position to do an equity financing.

The reason for those conditions is that priced equity financing rounds take a good deal longer to close and have a significantly higher cost involved in diligence, drafting, negotiating, and closing the financing round.  As mentioned above, this is one major reason why early-stage entrepreneurs and investors gravitated towards choosing SAFEs or convertible notes instead of engaging in a drawn-out and expensive equity financing process.

Conclusion

Generally, SAFEs are cheaper to execute and can deliver capital to companies quicker, and most of the time companies have to give up significantly less in the way of governance and approval rights to the investors. For that reason, we would typically recommend SAFEs for early-stage companies, particularly if such companies are raising below a certain threshold amount of capital (somewhere around $1.5 million). A bigger fundraising round likely makes more sense to negotiate the economic and governance terms in a more fulsome manner through the likes of a wholesale equity financing round.