The Ins and Outs of SAFEs
Safes (short for simple agreement for future equity) are the primary option elected in place of promissory notes. Safes, like notes, generally convert into preferred stock. The three main varieties of safes are outlined below.
Safes are converted to preferred stock at a specific conversion price. The conversion price is calculated, by default, by dividing the pre-money valuation by the fully-diluted capitalization.
Valuation caps serve as limiters to the pre-money valuation. By doing so, they increase the likelihood that safes will convert to preferred stock representing an agreed upon minimum percentage of the corporation. The caveat here is that there is no true minimum percentage of the company being exchanged, as the percentage of ownership will also be shaped by the amount others invest in preferred stock financing.
The conversion price can also be set to have a fixed discount from the price per share of preferred stock. The incentive for safe-holders is that they will be guaranteed premium pricing at each preferred stock offering.
Valuation Cap & Discount
Occasionally safes will carry both a valuation cap and a discount. One conversion method or the other is then used to calculate how many shares of preferred stock a safe will convert to. Generally, whichever is more favorable to the investor is the method selected.
In the event that a safe has not yet been converted to stock when the startup is acquired, the investor can either elect to have their investment returned in full, or to have the safe converted into common stock with the same valuation cap or discount that was scheduled for a preferred stock conversion.
When investors are in an advantageous negotiating position, they may ask that a safe be paid back at a higher price than it was purchased at — generally two times as much. This increases the required value for all other stakeholders to profit from the acquisition.