Editor’s note: This is part one of a two-part series about two financial instruments that angel investors use to more easily invest in early-stage startups. While this article is about SAFEs, part two will cover convertible notes.
In 2024, the size of the global angel investment market was estimated at about $28 billion. It is projected to grow to $72.35 billion by 2033. While such investments in startups can be highly profitable, they also carry significant risks. If an investor is willing to take on that risk, the next question is how to properly structure the deal.
Accredited investors can access both direct startup investments and syndicate deals. You don't need to be a U.S. resident to use the popular AngelList platform — providing proof of your accredited investor status is enough.
The most effective way for an angel investor to safeguard their interests is by acquiring shares in a startup directly.
However, with early-stage startups, this approach is uncommon due to the high legal costs and challenges in determining a fair valuation. Instead, to finance such startups, the venture capital industry relies on simpler financial instruments.
My portfolio includes 52 startups across different jurisdictions. The majority of them are backed by SAFEs, and occasionally I use convertible notes. I’d like to explain what these agreements involve and what factors to consider to improve your chances of growing or, at the very least, recouping your investments.
Spoiler alert: None of these agreements ensures that you’ll get your money back.
What is a SAFE?
A SAFE (simple agreement for future equity) is a brief six- to seven-page agreement between a founder and an investor. It works like this: The investor provides capital (purchase amount) to the startup now and receives company shares in the future.
A SAFE converts into shares when a triggering event occurs, called equity financing. This is a fundraising round where new investors are issued standard preferred stock. In contrast, the founder and the team own common stock.
A SAFE benefits startups in the following ways:
- It's not classified as debt, so it doesn't appear as a liability
- It has no predetermined date for conversion to shares
- It doesn't give the investor shareholder rights
Despite the risks, investors choose a SAFE because it is the easiest and quickest tool for investing in the early stages. The market standard is the post-money SAFE, which uses the valuation cap after the equity financing round (i.e., including the money received from investors in this round). I will focus on this version of SAFE below.
Important terms of a SAFE
- Valuation cap. This is the upper limit on the valuation at which the investor’s funds will convert into shares. If the actual valuation exceeds this cap, the early investor will receive a number of shares based on the valuation cap. In other words, they will acquire shares at a lower price than the price paid by investors in the equity financing round.
- Discount rate. Simply put, this is a reduction in the share price determined during equity financing. Based on my experience, the discount usually doesn't exceed 20%, meaning the discount rate is 80%. If Series A investors buy shares for $1, the SAFE holder will acquire them for 80 cents.
Series A is the first major round of funding for a startup after initial seed capital. Startups at the seed stage typically use the funds to validate their core hypothesis and identify a product that users are actually willing to pay for.
The seed stage is often referred to as the “angel stage,” as business angels are typically the primary backers of startups during their earliest phases of development. Series A funding is raised to scale a successful business model.
Types of SAFEs
The Y Combinator accelerator, which created SAFE, offers three variants:
- Valuation cap, no discount. This option includes a valuation cap but does not provide a discount for the investor. For example, if the purchase amount is $100,000, the valuation cap is $5 million, and the company’s valuation during equity financing is $10 million, the SAFE holder will receive: $100,000 / $5 million * 100 = 2% of shares. In comparison, Series A investors would receive 1% of shares for the same $100,000.
- Discount, no valuation cap. This option offers a discount to investors. With a $10 million valuation and a discount rate of 80%, an investor will receive: $100,000 / ($10 million * 0.8) * 100 = 1.25% of shares. The investors without the discount will get 1% of shares for the same amount.
- MFN, no valuation cap, no discount. This option includes an MFN clause, which I will explain below, and does not specify a valuation cap or discount.
A fourth version of the SAFE was widely used in practice in Delaware. Though it has been removed from Y Combinator, it continues to be used and combines both a valuation cap and a discount.
In this case, the investor can choose the more advantageous way to convert their investment into shares by either using the valuation cap or applying the discount rate.
For example, if the valuation cap is $5 million, the discount rate is 80%, and the equity financing round valuation is $10 million, it’s more advantageous for the investor to convert based on the valuation cap: They would receive 2% instead of 1.25% of shares (see the calculation example in point one above).
However, if the startup's valuation during equity financing equals or is slightly higher than the valuation cap, the scenario changes.
For instance, with a $5 million valuation cap, an 80% discount rate, and a company valuation of $6 million at equity financing, the investor would benefit more from the discount rate. They would receive $100,000 / ($6 million * 0.8) * 100 = 2.08% of shares, compared to 2% with the valuation cap.
I presented simplified calculations to illustrate the underlying principles. In practice, determining the number of shares during SAFE conversion is carried out using the formula specified in the agreement and takes into account a variety of conditions.
Which type of SAFE is more beneficial for the investor?
During deal negotiations, there’s no way to know which conversion method — valuation cap or discount rate — will ultimately prove more advantageous for the investor. The most favorable option for the investor is a SAFE that includes both a valuation cap and a discount.
However, these terms are not ideal for startups, and founders typically do not agree to them.
A SAFE with just a valuation cap allows the investor to understand the potential profit they’re risking for. I believe that a discount-only option without a valuation cap is unfair to early investors. They receive only a 20% discount, while their risks are not 20% lower, but are much greater compared to later investors.
The MFN (most-favored nation) clause enables investors to receive the same terms as future investors who sign a new SAFE with the startup. This type of agreement only includes the purchase amount.
The SAFE holder waits for another investor to secure favorable terms with the startup and then aligns with them. I have not been involved in such deals.
I use a SAFE that always includes a valuation cap and recommend that all novice business angels do the same. Accepting only a discount is reasonable when you're dealing with a promising startup that isn’t open to other terms.
However, the venture funnel is structured in such a way that such startups typically don't reach inexperienced investors.
How is an investor protected in a SAFE?
A SAFE does not offer the same protections as holding company shares. However, it includes other protective mechanisms, such as:
- Liquidity event. This usually refers to the sale of the company before an equity financing at a valuation lower than the valuation cap. In such cases, the investor can choose the most favorable option — either to get their purchase amount back or convert their investment into common stock and sell it.
- Dissolution event. This pertains to bankruptcy. If the company is dissolved, the investor is entitled to a share of remaining funds proportional to their investment. However, if the startup has no funds left, the investor will receive nothing.
A downside is the liquidation priority clause, which specifies that in the event of a sale or closure of the company, the investor receives their payout after creditors and holders of convertible notes.
In other words, there may not be enough funds left for the investor, which is a common occurrence in the venture world.
A side letter in a SAFE
A side letter is an agreement where the parties outline additional terms. While it’s not a required document, I strongly recommend negotiating its inclusion. Here are some provisions that might be found in a side letter:
- Pro rata rights. This gives investors the option to maintain their ownership percentage in the startup. For instance, if an early investor's stake drops from 10% to 5% after an equity financing round, they have the right to buy more shares to bring their ownership back to 10%. The shares must be purchased at the same price as those acquired by new investors, without any discounts for SAFE holders.
- Information rights. This clause ensures that early investors are kept informed about the startup’s progress, typically through quarterly and annual financial reports. The standard terms of SAFEs do not obligate startups to report to early investors, and as a result, they are often left in the dark.
My second article in this series will cover how to use convertible notes to invest in a startup, including some comparisons to SAFEs.
