The Startup Aspirin: SAFEs Ease Fundraising Pain, But Read The Fine Print First

By Ling Kong

In the ever-evolving world of startup finance, one instrument continues to dominate: the Simple Agreement for Future Equity, or SAFE. Born in 2013 as a Y Combinator innovation, the SAFE has become the go-to tool for pre-seed fundraising. According to Carta’s State of Startups 2024 report, nearly 90% of pre-priced rounds in Q3 2024 were raised using SAFEs.

Created as a lightweight, company-favorable alternative to convertible notes, SAFEs were designed to help startups close early capital quickly by eliminating interest rates, maturity dates or complex negotiation. They’re not debt and don’t confer equity upfront. Instead, SAFEs offer the right to convert into shares during a future priced round, typically at a discount or capped valuation.

Market mechanics: caps, discounts and dilution

Most SAFEs come with a valuation cap. Carta’s January to September 2024 data shows 62% are capped only, 29% offer both a cap and a discount, and just 9% offer a discount alone. Uncapped, no-discount SAFEs are now extremely rare, just 1%.

Although more founder-favorable, this data shows that it’s relatively uncommon for startups to be able to raise on a discount-only basis. Founders should be prepared to negotiate a valuation cap if using SAFEs.

To complete a typical pre-seed round, founders often raise capital from five to 15 investors using multiple SAFEs, each potentially with slightly different terms. That can complicate cap table modeling and surprise founders later. Median dilution from large SAFE rounds now hovers around 20%.

Founders need to be especially careful when raising large SAFE rounds with low post-money valuation caps. It’s easy to underestimate how much dilution they and other existing shareholders will need to bear given that the SAFE investors’ percentages are effectively fixed under the post-money valuation cap.

That said, most companies shift from SAFEs to priced equity when raising $3 million or more, seeking structure, predictability and cleaner books.

Evolution from pre-money to post-money

The original version of the SAFE used a pre-money calculation, which made it difficult for founders and investors to accurately predict dilution at a future priced round, especially when juggling multiple SAFEs, as additional SAFEs diluted both founders and existing SAFE holders.

To address this, Y Combinator introduced the post-money SAFE in 2018. This newer format calculates investor ownership more transparently by locking in the floor on the investor’s equity percentage based on the post-money valuation. For example, if $150,000 is invested on a $15 million post-money cap, the investor knows they will own at least 1% of the company immediately prior to its next priced equity round.

This anti-dilution protection can be particularly dangerous for founders and existing shareholders in down rounds or other distressed situations where they are forced to accept a lower post-money valuation cap to raise much-needed cash — as the number of SAFEs can quickly multiply with no priced round in sight, and the post-money SAFE holders are protected against dilution from other SAFEs or convertible notes.

Any anti-dilution protection of existing preferred stock that is triggered before the next equity round (e.g., by the company issuing bridge notes that convert at a lower per-share price than the prior round) is also factored into the calculation of the conversion price of the SAFE.

Today, over 85% of SAFEs issued are post-money as opposed to pre-money, a clear sign the market has embraced this clarity, even if it comes at the cost of being a less founder-favorable instrument.

Founders vs investors: weighing the trade-offs

For founders, SAFEs are fast, cheap and simple. Legal costs are low, investor negotiations are short, and control remains with the founding team. With no interest or repayment obligations, SAFEs keep cash in the business when it’s needed most.

But the disadvantages loom large. Founders often underestimate dilution, mainly with post-money structures. Stacking SAFEs can complicate later rounds, leading to cleanup provisions, legal rework and investor friction.

Investors — notably angels and microfunds seeking exposure to early-stage upside — like SAFEs for their simplicity. But SAFEs are risky. Without conversion, the paper may be worthless. And there are no voting rights, protections or board seats like those typically afforded to equity investors.

This risk-reward profile may be acceptable to experienced backers betting on breakout growth, but less palatable to traditional investors looking for more control and clearer downside protection.

The road ahead

In a fundraising environment still shaking off the highs of 2021, SAFEs remain a favored legal instrument for early capital. They’re particularly useful in sectors like AI, where speed to market is paramount and venture appetite is still relatively strong. For founders, the SAFE remains an essential tool, but one that should be wielded with care.

Ling Kong is a partner at Michelman & Robinson LLP, a national law firm with offices in Los Angeles, Irvine and San Francisco, California; Dallas and Houston, Texas; and Chicago and New York City. He has extensive experience advising emerging growth technology companies and investors, particularly those in the life sciences, consumer technology and real estate technology sectors.

Illustration: Dom Guzman