SAFEs Dominate Pre-Seed Funding, but Convertible Notes are Heating Up 🔥
5 Major Differences between SAFEs and Convertible Notes
The 2 Types of SAFEs and Their 5 Variants, One Key Difference
YC’s Secret SAFE is Basically the Standard YC Post-Money Cap
All Y Combinator insiders know this little secret, but there’s an off-menu SAFE that YC uses to invest in its startups.1 YC provides its startups with $125K in cash for 7% fixed ownership, implying an effective post-money valuation cap of $1.78M.2
Unlike other SAFEs that rely on a valuation cap or a discount, the YC SAFE relies on a “Conversion Percentage” to determine the number of shares issued in the next round.3
We’ll explore how the YC SAFE works and compare it to other SAFEs, but first:
Q: Where can you find a Conversion Percentage SAFE form to download?4
Disclaimer: This form is not authored, endorsed by or affiliated with Y Combinator (“YC”). It has been marked up and commented to ensure fair use. To access the YC official SAFE forms, please visit https://ycombinator.com/documents. The YC SAFE is made available under a Creative Commons Attribution-NoDerivatives 4.0 License (International): https://creativecommons.org/licenses/by-nd/4.0/legalcode. Use of this form is strongly discouraged without engaging legal counsel. Definitely not legal advice. Not responsible.
The Data on SAFEs vs. Notes
Over the past few years, SAFEs have emerged as the dominant financing instrument for early-stage venture deals—and it is not even close.5
Stage-Specific: In the last quarter of 2023, nearly 90% of all pre-seed dollars were closed on SAFEs. SAFEs were also used in 50% of seed deals (including equity).7
SAFE-Specific: 80% of these agreements were on post-money SAFEs with a cap.
Sector-Specific. While SAFEs dominate most sectors, including SaaS, Fintech, Gaming and Edtech, Convertible Notes make up at least 30% of pre-seed funding in Medical Devices, Pharma/Biotech, and Energy.
But Convertible Notes Are Heating Up 🔥
Q: How common are SAFEs vs. Convertible Notes in other stages in 2024, given interest rates?
The domination of SAFEs largely depends on what stage of financing we’re looking at. Capital has a cost, and Aumni’s data from Q4 2023 shows that Convertible Notes are fueling that cost of capital—75% of convertible financings were done on Notes:
Q: How can we reconcile the contradictory data sets from Carta and Aumni?
Aumni’s chart was filtered for all venture stages, while Carta’s focus was pre-seed, which is a different beast. The key takeaway is that SAFEs are favored in pre-seed and seed stages, Convertible Notes are favored in later financing rounds (Series A - D+).8
Investors preferences begin to shift from SAFEs to Convertible Notes at Series A:
Against that backdrop, there are also a few other macro factors at play:
Interest Rates Are Still Very Much In Vogue: Interest rates on Notes continue to climb and have doubled from 5% in 2019 to just under 10% in late 2023.9
The Number of Days Between Rounds are Increasing: Today, the median gap between a priced seed and Series A has stretched to over 1.8 years, and from Series A to Series B over 2 years.10
Discounts Are Increasing: While interest rates continue to climb, the premium offered by discounts has become more aggressive, with convertible notes issued on a discount at or over 20% increasing to 85% of all convertible notes in 2023.11
That being said, there will always be outliers that buck the trend:
Fundamentals of the SAFE
SAFEs enable founders to secure funding quickly, cheaply & simply without (i) setting a valuation, (ii) giving up control rights, or (iii) requiring legal fees.
SAFEs are the preferred choice for founders because they do not accrue interest, have no maturity date, and convert into equity at an equity round, merger, or sale.
At five-pages long, the SAFE was built for fast, high resolution financings.
Founders can have rolling closes instead of squeezing investors into a single close.
Negotiations can be deferred to the next priced round for board seats, liquidation preferences, protective provisions, M&A and veto/control rights.
Five Major Differences Between SAFEs and Notes
SAFEs work just like convertible notes but with five major differences—SAFEs have:
no interest rate;
no maturity date (which means that SAFEs can sit in perpetual limbo until the company raises an equity financing, finds an exit, or dissolves);12
no minimum qualified financing (unlike notes which often require minimum fundraising thresholds such as “$2.5 million, excluding all notes and Safes”);
“Safe Preferred Stock” issued in the next equity round (Shadow Series); and,
IRS Code §1202—Qualified Small Business Stock (QSBS)—explicitly referenced.13
Shadow Series
Of the five categories listed above, Safe Preferred Stock has had the most significant influence on the venture capital industry by standardizing the terms of Preferred Stock. This is evident from an analysis of the capital structures of Series A charters:14
Key points:
Shadow Series protects against liquidation preference overhang and ensures fair treatment for anti-dilution protection, dividends and liquidation payouts.
They receive the same rights and privileges as the main series, except for the conversion price and name.15
The conversion price fairly reflects the amount of cash the Safeholder invests.
The key feature of Shadow Series is that SAFEs are converted into shares identical to the next round’s shares, except for the “per share liquidation” price:16
For example, if a SAFE converts at $0.80 per share and the company sells preferred stock at $1.00 per share, assigning the Safeholder the same $1.00 liquidation preference would give them a windfall - their preference should be what they paid in cash, $0.80 per share, not the additional $0.20 per share, which is something the investor received for free.
The impact of Shadow Series extends beyond its mechanics. Because SAFEs convert into identical shares at the next equity round, it slows down investors who might demand special rights and privileges. If such demands were made, all Safeholders would receive the same rights and liquidation preferences, leading to a snowball effect.
For example, if new investors pushed for 2x liquidation preference, with participation rights (a very hairy deal), Safeholders would receive the same stock.
As a result, the market has converged around a common standard: 1x, non-participating preferred stock.
This market standard has held relatively firm despite significant down round activity in the venture market last year.17
Two SAFEs, Five Variants, One Key Difference
These are only two official types of Y Combinator SAFEs: Pre-Money and Post-Money.
What is a Pre-Money SAFE?
The original YC safe from 2013 was a “pre-money” safe because the valuation cap in the original safe was based on a pre-money valuation.
For example, if a company raises $2 million at a $10 million pre-money valuation, that’s the same as if it raised $2 million at a $12 million post-money valuation.
A post-money valuation and a pre-money valuation are just two sides of the same coin, framing the valuation of the company at different points in time:
A pre-money valuation is the valuation of the company immediately before the company receives new investment on the financing in question.
A post-money valuation is just the valuation after the new investment is made.
What is a Post-Money SAFE?
The post-money safe is now the official version of the SAFE. It gives the parties an easier way to understand how much of the company the SAFE holder will own immediately prior to the next equity financing (it also removed pro rata rights by default that was in the Pre-Money SAFE).
Let’s say a Safeholder invests $2 million on a $12 million post-money valuation cap. With the Post-Money SAFE, that Safeholder should have 16.66% at the next equity round of financing, but before any new stock pool expansion and before preferred shares are issued to the new investors, but AFTER all other convertible notes, pre-money SAFEs, post-money SAFEs or outstanding capital stock.
In a priced round, assuming all SAFEs are on a post-money basis, three things usually happen simultaneously but the calculations are ordered specifically:
All Safes and other convertible instruments convert into “Safe Preferred Stock” (e.g., Shadow Series, such as Series Seed-1 Preferred Stock, Series Seed-2);
An option pool is created or increased after the SAFEs convert;
New money is invested in the company at the price per share [PPS] of the preferred stock sold in the equity round.
Immediately after step #1, the investor will convert its SAFE and own X% in the company; where X% = Safe Investment Amount / Valuation Cap. For example, a $2 million SAFE investment on a $10 million valuation cap is equal to 20% of the company at the time of conversion (which will be diluted by any expansion of the option pool and new money).
Five Variants of SAFEs
Each of the two SAFE types has 5 variants, ranked in order of their popularity:18
The most important term in any capped SAFE is “Company Capitalization”, which is just the total number of shares in the company for purposes of calculating the conversion price immediately prior to the next equity round.
Pre-Money SAFE “Company Capitalization”:
Post-Money SAFE “Company Capitalization”
Visually, this is what the pre-money vs. post-money difference looks like in a chart:
Here are the two types of SAFEs plotted against the chart above:
Pre-Money SAFE: The pre-money SAFE includes the option pool expansion but excludes all “SAFEs, convertible notes and other similar convertibles.”
Conversion Percentage * Company Capitalization = Shares of Safe Preferred Stock
As stated earlier, the “Company Capitalization” is just the total number of shares in the company at the time of conversion, which calculates all SAFEs immediately before the company raises an equity financing event, such as a Series Seed or Series A.
For example, if a startup receives $125,000 in exchange for a 7% YC SAFE, the implied valuation cap is $1.78 million:
$125,000 / 7% = $1,785,714.28
But this is unlike the Standard Post-Money Valuation Cap SAFE, where the implied ownership is calculated by dividing the Amount Raised by the Valuation Cap:
Amount Raised / Valuation Cap = Implied Ownership %
$125,000 / $1,785,714.28 = 7%
Why Should We Use the YC SAFE (Conversion Percentage)?
The key advantage of the YC SAFE (Conversion %) is to simplify negotiations by avoiding a valuation cap or discount and just using what we all intuitively know:
"One of the immutable laws of venture capital is that there are only 100 points on the cap table."—Sam Altman, on Dilution
So, if you know your check size & what target allocation you need on the cap table, you can use a Conversion Percentage.
This approach can even be more founder-friendly compared to a post-money valuation cap, which represents a minimum ownership percentage and increases if the cap does not exceed: (i) the pre-money valuation at the next equity financing round, (ii) or the discount, if one applies.
Despite the potential benefits, YC has not released the YC SAFE to the public. It’s impossible to see how the industry will move to the YC SAFE unless it is available.
What Are Some Problems with the YC SAFE (Conversion Percentage)?
There are three potential issues with using this form:
The conversion percentage is technically more founder-friendly compared to a post-money valuation cap, which represents a minimum ownership percentage. But the trade off for certainty with a fixed ownership percentage seems worth it.
The second issue with the YC SAFE is its low acceptance rate will probably not make it worth trying to explain. Even if this form is more company-friendly, the only way this instrument gets mass adoption is if YC makes it official. YC should release their form to the public, it would be a public good!
Finally, this new form disrupts the amendment process in section 5(a) because it’s technically a different type of Safe without a valuation cap or a discount:
Conclusion
Valuation caps are just proxies for the truth. Ownership matters. It would be easier for the parties to negotiate over something they intuitively already know.
Instead of haggling over uncapped SAFEs and valuation floats, why not just get to the point of what we’re all trying to say:
How many points on the cap table are you willing to buy or sell?
SAFE stands for “Simple Agreement for Future Equity”—it’s sometimes referred to as a “SAFE Note” or by Y Combinator, officially, it’s just a “Safe” or “safe”. The YC SAFE that Y Combinator uses is not available online or anywhere.
YC’s standard deal is 7% for $125K, plus a $375K MFN SAFE and pro rata rights:
In other words, YC invests $500K in every portfolio company and receives three things in return: (1) a $125K post-money safe for 7% of the company, (2) a $375K uncapped MFN Safe, and (3) a pro rata rights side letter:
While convertible notes are more common than SAFEs in later stages, convertible securities start to become less frequent as the company progresses through the financing stages:
The SAFE will convert into equity shares when one of three trigger events happens: (1) an “Equity Financing” (new equity round such as a Series Seed/A/B/etc.); (2) a “Liquidation Event” (sale or other change of control of company); or (3) a “Dissolution Event” (company goes bust). In other words, the SAFE operates like an IOU that converts into shares later.
The three trigger events use the following terms:
New equity round
“Equity Financing” means a bona fide transaction or series of transactions with the principal purpose of raising capital, pursuant to which the Company issues and sells Preferred Stock at a fixed valuation, including but not limited to, a pre-money or post-money valuation.
For example, when a company closes its Series Seed equity financing, the lead investor acquires “Standard Preferred Stock”, which is just like Series Seed Preferred. At the same time, Safeholder will be issued a variation called “Safe Preferred Stock”, defined as follows:
“SafePreferred Stock” means the shares of the series of Preferred Stock issued to the Investor in an Equity Financing, having the identical rights, privileges, preferences, seniority, liquidation multiple and restrictions as the shares of Standard Preferred Stock, except that any price-based preferences (such as the per share liquidation amount, initial conversion price and per share dividend amount) will be based on the Safe Price.
Sale of the Company or Going Public
“Liquidity Event” means a Change of Control, a Direct Listing or an Initial Public Offering.
Change of Control: This is an M&A and occurs when a new owner or group gains control of the company, either by acquiring more than 50% of the voting shares, through a merger or reorganization, or by purchasing most of the company’s assets.
Direct Listing: This happens when the company lists its shares directly on a stock exchange without going through a traditional IPO process.
Initial Public Offering (IPO): This is the traditional process of offering shares to the public for the first time through an underwritten offering.
In a Liquidity Event, a Safeholder is entitled to receive up to the greater of (1) a return of their initial cash investment (1x return), or (2) the converted proceeds as if it were entitled to stock in connection with a Liquidity Event (i.e., the cash it would have received had the SAFE been converted into common stock at the Post-Money Valuation Cap).
In a Liquidity Event, the SAFE ranks junior to creditors and outstanding indebtedness (including outstanding convertible notes) so it has the same priority as standard 1x non-participating Preferred Stock.
Essentially, a Liquidity Event is a fundamental change in the company’s ownership or structure, creating an opportunity for Safeholders to realize their investments.
Winding Down and Dissolution
In a Dissolution Event, the company is shutting down, so the Safeholder is entitled to receive up to 1x their cash investment.
Here is the definition of “Safe Preferred Stock” and “Standard Preferred Stock” in the SAFE:
This ensures that Safeholders receive not only the same rights as the new investors in this round, but a fair liquidation preference based on their original investment, rather than benefiting from a higher valuation in the next round.
Shadow Series: For example, if lead investor has “Series Seed Preferred Stock,” a Safeholder should receive “Series Seed-X Preferred Stock”, where “-X” is the number that matches their cap table conversion, Series Seed-1 Preferred Stock.
Before the SAFE, early-stage startups frequently used convertible notes which converted into the next round’s shares without a shadow series. Until recently, law firms remained skeptical of SAFEs and of Shadow Series as potential violations of corporate law.
Here’s the argument (not endorsed by me): Shadow Preferred Stock can be risky due to the potential complications it creates under Delaware General Corporation Law §242(b)(2). This section grants blocking rights to stockholders of any class of stock, allowing them to prevent amendments to the certificate of incorporation that negatively affect their rights.
When Shadow Preferred Stock is created to address the liquidation preference overhang issue, it forms a separate series of stock. This means the former Safeholders, now Shadow Preferred stockholders, potentially gain blocking rights under §242(b)(2). These rights arise when certain company actions are at stake such as:
Recapitalizations: If the company needs to restructure its capital structure, it might require all preferred stockholders to give up certain rights. Shadow Preferred stockholders could use their blocking rights to prevent the recapitalization.
M&A transactions: Similarly, mergers or acquisitions might require changes to the company's capital structure. Shadow Preferred stockholders could use their blocking rights to impede these transactions.
In some cases, the cost of the liquidation preference premium might be relatively small. They might pay out the amount in commons stock or cash to clear the deck. But honestly, this seems like a losing argument to me. We shall see if anyone successfully argues the point, but no one has taken a swing yet—and there’s probably a very good reason why.
It remains to be seen whether the early-stage cluster of 1x non-participating preferred stock will have an impact on the broader industry effects. If it does, changes are more likely to creep in at the later stages, where there are fewer convertibles and investors have more flexibility to negotiate liquidation privileges without triggering a snowball effect. It’s important to note that Q1 of 2023 saw a spike in participating preferred and >1x liquidation multipliers but this impact seems to have been mostly contained at the later stages, which has its own drag on special rights but not as pronounced as the earliest stage deals.
One way to compromise to the definition of Company Capitalization is to just add a few words to include all convertibles that existed prior to the SAFE but exclude any new convertible security with different cap: (hat tip to José Ancer—Downloadable PDF):
⬛ When dealing with Post-Money SAFEs on a Valuation Cap and Discount, the Discount applies even after the Pre-Money Valuation at the next equity round reaches the Valuation Cap, up to a point (highlighted in yellow):
This is counterintuitive because the discount will apply even after the valuation cap is reached, until the pre-money valuation at the next equity round is greater than$X:
$X = Valuation Cap / Discount Rate
Note: This only applies to a CAP + DISCOUNT Safe, not to a Discount only.
Example: $10M Valuation Cap & 20% discount with $12M pre-money valuation at the Seed (priced) round. Which Safe conversion price applies - $10M cap or 20% discount?
The Discount Rate: 1-0.20 = 80%;
$X = $10M / 0.80 = $12.5M
Because $12.5M > $12M we apply the Discount. ✅ An odd result!
In other words, the discount would provide a conversion at 80% of the $12M valuation, which is $9.6M. Since the valuation cap is $10M and the effective valuation with the discount is $9.6M, the discount would indeed provide a better (lower) price for the investors, and therefore, the discount would apply.
Once you know that the only term that really matters on capped SAFEs is the Company Capitalization, it may not shock you to know that all uncapped SAFEs, whether pre-money or post-money, result in the same conversion outcome.
For example, a Pre-Money SAFE with a 20% discount will yield the identical conversion price as a Post-Money Safe with a 20% discount. The same outcome is also true of the MFN (Most Favored Nation) SAFE form.
Disclaimer: This article is intended to provide VCs and founders with an overview of the key aspects of the SAFE. However, it is not intended to be an exhaustive resource, and other factors may apply to your specific situation. You are strongly encouraged to seek guidance from experienced legal counsel to ensure compliance with the issues discussed above.
