Key Takeaways:

• 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. YC provides its startups with $125K in cash for 7% fixed ownership, implying an effective post-money valuation cap of $1.78M.

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.

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?

Download the Conversion % SAFE

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.

Over the past few years, SAFEs have emerged as the dominant financing instrument for early-stage venture deals—and it is not even close.

SAFEs Dominate Pre-Seed

• 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).

• 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.

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+).

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.

• 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.

• 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.

That being said, there will always be outliers that buck the trend:

• 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.

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);

• 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.

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:

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.

• 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:

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.

These are only two official types of Y Combinator SAFEs: Pre-Money and Post-Money.

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.

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:

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).

Each of the two SAFE types has 5 variants, ranked in order of their popularity:

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.

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:

Calculating the Ownership Percentage sold in a Post-Money SAFE is simple:

Investment Amount / Valuation Cap = X% sold at the SAFE’s conversion trigger.

The formula to convert the YC SAFE with a Conversion Percentage (link) is essentially the same formula as the Post-Money SAFE, which implies the ownership %:

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:

$125,000 / $1,785,714.28 = 7%

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.

There are three potential issues with using this form:

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?

Simple.

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