The Case For The Uncapped SAFE

Earlier this week, Peter Walker of Carta shared data on the use of different mechanisms in SAFEs issued for U.S. startups in 2024: 61% used a cap, 30% used a cap and a discount, 8% used only a discount, and 1% used neither.

In response to the number of uncapped SAFEs, or a Simple Agreement for Future Equity, one investor replied, “That tells me at least 1/12 VC funds has no idea what it’s doing.”

Such is the legacy of the uncapped SAFE, now synonymous with price bubbles, reckless fundraising and investors getting burned.

Origins of the uncapped SAFE

In August 2021, Y Combinator (originators of the SAFE) updated their SAFE templates to remove the version that included both a cap and a discount, and clarified with this note:

“YC’s recommendation to founders was to issue either the valuation cap flavor safe or the discount flavor. We did not encounter situations where the combo safe was the preferred choice. Accordingly, we decided it was incongruous to make this version available.”

It begs the question: Why does YC see a case for the discount-only SAFE (~8% of SAFEs), but not the discount and cap SAFE (~30% of SAFEs)?

The purpose of caps and discounts

Both mechanisms are intended to offer early investors preferential entry when the investment converts to equity at a future priced round.

• Caps are intended for startups with a more practically forecastable future, like SaaS or e-commerce. The cap should reflect projected growth at that point in time, as well as the additional risk that SAFE investors have taken in the interim.
• Discounts are intended for companies that have front-loaded risk, with too much uncertainty to define a reasonable cap. Consider a startup raising a SAFE to prototype hardware, take a drug through clinical trials, or fund large-scale pilot projects.

This is what YC understood: Caps and discounts solve the risk problem from two different perspectives.

The habit of combining the two, where a discount is applied if a startup raises at or below its cap, is punitive. In that scenario, investors should be looking to put startups in the strongest position for future growth, not diluting them further.

Combination SAFEs have also warped expectations for discount levels. The median discount of 20% reflects the role of backstopping a cap, and is far less meaningful as a standalone mechanism. It’s not appealing compensation for risk at that level, but equally founders may be uncomfortable with investors suggesting something much higher than the median without a clear basis.

Updating the SAFE discount

What YC missed in the original creation of the SAFE discount was how fundraising would evolve: Over time, SAFEs would be raised more frequently, stacked on top of each other, and founders would need encouragement to do a priced round and execute the conversion.

Caps work well here, as the company grows and the implied dilution becomes more uncomfortable. This isn’t as true for the (flat) discount, which makes the case that SAFE discounts should compound over time. In fact, looking at the required ROI for venture capital as a basis for calculating discounts has a logical elegance, ensuring investors are appropriately compensated for risk.

The outcome of this approach would be much larger discounts (in excess of 50%), but applied without a cap — offering greater flexibility for startups at the extreme end of the risk/reward spectrum. Dilution outcomes still fall into a practical range, especially for startups on a path to rapid (but capex expensive) growth.

It would bring new life back into a valuable fundraising tool that has fallen into misuse, just in time for 2024’s renaissance for hard tech founders.

Dan Gray, a frequent guest author for Crunchbase News, is the head of insights at Equidam, a platform for startup valuation, and a venture partner at Social Impact Capital.

Illustration: Dom Guzman