What is a safe?The Safe over timeKey elements in a safe:Valuation capDiscountMost favored nationPro-rata side letterWhy safes?Additional background
The Safe (simple agreement for future equity) was introduced by Y Combinator in 2013, and are now a widely adopted financing instrument for early-stage startups (and a typical way to finance “pre-Seed” stage companies).
Safes are standardized agreements (that are similar to warrants or options) for equity in a business that enable investment into a company without a defined purchase price to be determined at a later date and set by certain conditions.
Safes are a form of convertible instrument which acts as a standardized non-debt payment for deferred purchase of preferred stock to a priced round at an equal to or lower price determined by components dictating conversion mechanics.
The Safe was revised in 2018 to better reflect how the instrument was used in practice (where instead of investment as a direct precursor bridging a later priced round, safe investments were used towards early rounds on their own without an intent to value the company in the near term).
Safes are triggered by the purchase of equity in a round where there is a defined purchase price and the purchase price of shares for safe holders is defined in relation to that purchase price. How the price of a safe compares to the price in a priced round is defined by the financial terms associated with the safe.
A valuation cap places a cap on the valuation of the business at a certain capitalization. For the post-money (current, since 2018) safe, the valuation cap is the value of the business that includes:
- outstanding shares of capital stock,
- outstanding options,
- promised options,
- the unissued options pool,
- and all safes and convertible instruments themselves,
- excluding any increase to the options pool associated with the priced round.
The valuation cap divided by the total number of shares in that capitalization is what determines the share price for the safe holder.
A discount (which is often expressed as 1 - discount through a “discount rate”) is another way of determining share price for convertible instruments when they convert with the price of those instruments being discounted relative to the price of shares in a priced round.
Safes without a discount or cap will typically have a most favored nation clause which will mean that the terms of that safe will adjust so no new investment that comes in will have better terms. Safes without a discount or valuation cap are otherwise at the same price as the later priced round and investors at that round would have additional time to see the business make progress.
A pro-rata side letter is an additional agreement that can be included in a safe agreement, which typically grants the investor the right to participate in future financing rounds to maintain their percentage ownership in the company. This means that if the company raises another round of financing, the investor has the right to invest additional funds to maintain their ownership percentage, in proportion to the size of the new round.
Safes are advantageous for both founders and investors in early-stage companies because they provide a simple, standardized way to invest without having to determine a purchase price upfront.
This makes the investment process quicker and less complicated, and avoids the need for a company valuation in the early stages. Safes make it simple to invest in a company at an earlier stage when the valuation is likely to be more challenging to assess and simplifies potential negotiations.
See additional background on YC safes: