SAFE (Simple Agreement for Future Equity) – A Game Changer in Startup Financing

Simple Agreement for Future Equity has transformed the way startups are financed by providing a flexible and effective alternative to conventional methods. Among its variants, the Post-money SAFE has become the most popular lately due to its features that offer greater transparency and security to both investors and entrepreneurs. This article examines the Post-money SAFE from a legal and practical perspective, highlighting its benefits over the Pre-money SAFE and explaining why it has gained relevance in the current startup financing scenario.

Both the Pre-money SAFE and the Post-money SAFE allow investors to acquire conversion rights for their investment into future company shares at a pre-agreed price based on a future transaction or capitalization funding round. Although both legal instruments use the company's capitalization (or valuation) as a reference, the definitions of "Company Capitalization" differ between a Pre-money SAFE and a Post-money SAFE, generating significant legal implications that impact the share structure and shareholders' rights due to the conversion formulas applied in each case.

Before addressing the differences between each type of conversion formula, it is relevant to mention some technical aspects found in both. Firstly, these formulas can establish a "Valuation Cap" or a maximum limit on the company’s valuation. When the capital financing round occurs, the SAFE converts into shares. The number of shares received by the SAFE holder is calculated as: (SAFE Investment Amount) / (Conversion Price), where the "Conversion Price" is the lower of: a) The price per share of the new capital financing round; and b) The price per share calculated using the "Valuation Cap." The price per share using the Valuation Cap is calculated as: (Valuation Cap) / (Company Capitalization). It is evident from the above that the "Valuation Cap" acts as a safeguard for investors, ensuring that their investment converts at a valuation that does not exceed this cap regardless of the actual valuation in the financing round. Additionally, in both types of SAFEs, a discount can be applied to the share price in a future financing round, meaning that SAFE investors could acquire shares at a lower price compared to new investors.

As for the moment of the SAFEs' conversion, it generally takes place during a future financing round or other specific events such as the sale of the company. The issuance of new shares during the conversion of the SAFEs generally leads to the dilution of existing shares, so it is essential to correctly calculate this impact to understand how future share ownership will be structured. SAFE investors may have preferential rights that allow them to acquire additional shares in subsequent rounds to maintain their current ownership percentage.

Pre-money SAFE

As mentioned earlier, both in a Pre-money and a Post-money SAFE, the reference point used to calculate the conversion at the time the Valuation Cap is applied is the company's capitalization. In a Pre-money SAFE, this capitalization is determined according to the company's financial situation before receiving the new investment, without considering the additional funds that will be obtained. This includes:

• All issued and outstanding Capital Stock shares, assuming the exercise or conversion of all outstanding options, warrants, and other convertible securities, both those with vested rights and those not vested.

However, from the above definition, the following are explicitly excluded:

• the SAFE (and all other issued SAFEs), as well as convertible notes; and
• All shares reserved and available for future grants under equity incentive plans or similar company plans, or any similar scheme created or increased in connection with Capital Financing.

This definition of the company's capitalization introduces uncertainty when calculating the dilution of current shareholders, as it does not consider the new investment, nor other convertible instruments or option pools, which could result in greater than expected dilution. In this context, the percentage of shares received by the investor is calculated by multiplying by 100 the amount resulting from dividing the investment by the total company capitalization before the investment.

On the other hand, a Post-money SAFE defines the company's capitalization more broadly and includes the new investment. This means that it is established after receiving the invested funds and includes (explicitly indicating that they are not counted twice) the previously mentioned and defined elements:

• All issued and outstanding Capital Stock shares;
• All issued convertible instruments, including the SAFE itself;
• All issued and outstanding options, as well as promised options;
• and includes the Unissued Options Pool, usually stipulating that it will only be included to the extent that the number of promised options exceeds the pool of unissued options before the financing round.

This description offers a clearer view of how ownership will be distributed after the investment. Dilution is calculated more predictably and transparently, as the post-investment value of the company includes the new capital. In this scenario, the percentage of shares is determined by multiplying by 100 the amount resulting from dividing the investment by the capitalization after the investment in the company, which cannot exceed the agreed limit and includes all outstanding shares, options to acquire shares, warrants, and any other convertible rights issued both before and after the investment.

In either case, the Company's Capitalization is crucial because it determines the denominator in the calculation of the share price when the Valuation Cap is applied. A definition that implies a greater capitalization means a lower share price, which should result in a greater number of shares for the SAFE holder, while a smaller capitalization has the opposite effect.

The Post-money SAFE, by incorporating the new capital into the valuation, provides greater transparency about how the shares will be distributed after investing. This transparency is vital for building trust among investors, as it allows them to assess more accurately the impact of their investment. With this detailed information, investors can calculate more precisely their future share ownership after converting their contribution, thus offering a clearer and more precise vision of the future capital structure.

In a competitive environment, the Post-money SAFE offers greater transparency and security, facilitating quicker and more effective agreements, representing a significant advance in the financing methods for startups. The documents of the Post-money SAFE are usually simpler and more direct, reducing the need for lengthy negotiations and legal reviews. Moreover, the structure of the Post-money SAFE often better aligns the interests between founders and investors, establishing solid and trustworthy relationships between entrepreneurs and investors, which is crucial for the long-term success of the company.

On the other hand, a key disadvantage of the Pre-money SAFE is the complexity and uncertainty in calculating dilution. Because the company's capitalization is calculated before a new investment, the new capital entering with that investment is not considered. This can lead to situations where dilution, both for existing shareholders and new investors, is greater than expected. This uncertainty can generate distrust and conflicts among investors, who might be surprised by the level of dilution once the investments are converted into shares.

The Pre-money SAFE complicates financial planning for both entrepreneurs and investors. Entrepreneurs often face the challenge of anticipating how future financing rounds will affect their companies' ownership structure. This lack of certainty can negatively impact the ability to plan for growth and the financial strategy of the company. Investors may find it difficult to calculate accurately their future shareholding in the company, which could generate doubts when investing.

In the case of agreements based on a Pre-money SAFE, extensive negotiations are common to reach a consensus on the valuation prior to the investment. These negotiations tend to be costly and time-consuming, increasing legal and administrative expenses for both parties. The lack of a clear and predictable framework can lead to conflicts and delays in closing financial rounds, which can be especially harmful for startups that need capital quickly to expand.

By reducing the uncertainties related to dilution and future valuation of the company, as well as by offering greater transparency and clarity, Post-money SAFEs can be more attractive to a wide range of investors. Moreover, the structure of the Post-money SAFE helps investors have a better understanding of the real value of their investment in relation to the total capital invested in the company.

Although both the Pre-money SAFE and the Post-money SAFE seek to simplify the process of raising funds, the essential differences between them and the disadvantages pointed out of the Pre-money SAFE favor the use of the Post-money SAFE today. This has resulted in its growing acceptance in the startup environment, while the use of the Pre-money SAFE has become increasingly less common.