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Financing with SAFE Preferred Stock


Many startups struggle with fundraising. There are many factors to consider, and one of the most significant decisions to make is how much ownership to give up and how to do it. Convertible notes are famous among startup founders because of their ability to raise funds without a formal valuation. Convertible notes are a type of loan made to a company that converts into company stock at a later date (the “maturity date”). However, convertible notes are a type of debt. Debt means a maturity date and an interest rate. This puts pressure on the company to pay off the note by maturity.

 

As an alternative to convertible notes, Y Combinator created SAFE (Simple Agreement for Future Equity”) financing. SAFE is a type of preferred stock that has a conversion discount and a valuation cap. Like convertible notes, SAFE allows an investor to mitigate upside risk by purchasing a future stake in a company and lets founders raise funds without a formal valuation.


The way SAFEs work is simple. An investor invests money into a company and receives a SAFE that converts into preferred stock at the company’s next financing round (raising money) on a later date. Since SAFE is not debt, there’s no maturity date and no interest. This alleviates pressure from the company as they can operate without the fear of impending doom from defaulting on the convertible note.



There are three types of SAFEs: (i) SAFEs with a conversion discount, (ii) SAFEs with a valuation cap and (iii) SAFEs with both.


A conversion discount is a significant negotiation point when dealing with SAFEs. A conversion discount is a discount on the price an investor pays to convert their SAFE into company stock. For example, an investor with a 20% conversion discount for a company raising money at $2 per share would receive their shares for $1.60 per share (a 20% discount from the $2 per share non-SAFE investors pay).


Valuation caps are also a prominent negation topic when dealing with SAFEs. A valuation cap sets a maximum price the SAFE investor will pay for converting their shares. For example, assume a SAFE investor has a $3 million valuation cap for a company with a valuation of $10 million and 5 million outstanding shares. Whereas non-SAFE investors would receive their shares for $2 per share ($10m valuation divided by 5m outstanding shares), SAFE investors would be capped at a $3 million valuation. SAFE investors would thus receive their shares for $0.60 per share ($3m valuation cap divided by 5m outstanding shares).


If a SAFE has both a conversion discount and a valuation cap, the SAFE investor will convert at whichever share price is lower.


Many startups like SAFEs because they can avoid worrying about hitting milestones by a specific date or negotiating due date extensions, as they may have with convertible notes. Startup founders also like that they can raise funds without giving away control rights (e.g., board seats and voting rights) right away.


 


Conclusion

When raising money for your startup, SAFEs offer a great way to raise funds without paying interest and worrying about maturity dates. Of course, every situation is different, and it’s essential to consider the facts of your case before following what you read on the Internet. Contact Jabbour Law today to schedule a free 1-hour initial consultation to learn more about how we can help!


 


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