In the last few years, we’ve seen an increase in the number of convertible notes used on NZ cap raises. Some companies and investors have been using SAFEs – the instrument created by Y-Combinator (YC) several years ago. In 2015, we created our own Kiwi SAFE template which you can access here.

About two years ago, YC reinvented the SAFE and launched what is now known as the ‘post-money’ SAFE. As we’ve been receiving a few questions lately on how these work, here’s a brief analysis.

quick reminder – what’s a SAFE?

A simple agreement for future equity – in short, it’s an instrument convertible into shares similar to a KISS or convertible note. What’s different with a SAFE is that it doesn’t typically have any interest accruing, nor any maturity date and repayment obligation. They are therefore seen as a founder friendly investment tool to raise capital.

Like KISSes and other convertible notes, SAFEs typically convert into shares on the basis of a conversion price which is usually an agreed discount to the price of the next equity round, but which is subject to an overall valuation cap – i.e. whichever gives the lower price for investors.

so, what changed with the ‘post-money’ SAFE?

post-money SAFEs don’t dilute each other (bad news for founders)

The main change is that the new SAFE uses a post-money valuation cap instead of pre-money. The drafting change is fairly subtle to see: the definition of Fully Diluted Capital in the SAFE is amended to reflect the new principle. However, the impact can be significant. It means that the company’s valuation for calculating the conversion is “post” (i.e. after) the conversion of any other SAFEs or convertible instruments issued by the company, but prior to the valuation of the company immediately after the equity financing round. This results in further dilution for founders on conversion and potentially to any other investors that do not hold post-money SAFEs.

Just to be clear and to dispel a myth, by ‘post-money’, this is post all other SAFEs and convertible notes, but not post the next equity financing as well, as some founders have asked. That really would cause dilution!

Under post-money SAFEs, the post-equity financing option pool is no longer factored into the pre-money calculations, which actually benefits founders from a dilution perspective. Under the original SAFE, option pool expansions resulted in SAFE investors receiving additional shares. However, overall this doesn’t balance out the additional dilutive effect outlined above.

you’ll only feel the impact with multiple rounds of SAFEs

It is worth pointing out that for a company that only ever raises one SAFE investment round, a post-money SAFE has no real impact. Rather, it comes into play when more than one series of SAFEs or other convertible notes are issued. In NZ, we see this much less commonly than say in the US or Asia where substantial amounts are often invested using SAFEs and other convertible instruments, and not only in the first round of investment.

easier to calculate cap table (good news for founders)

YC’s view at the time of launching the new SAFE was that it makes the maths simpler for everyone and creates more certainty over ownership and dilution. Which is probably true. But if you issue more than one round of SAFEs or other convertible notes, and you use post-money SAFEs, founders will likely experience more dilution on conversion than they would have done under the original YC SAFE, simple as that.

In light of this, if presented with a post-money SAFE, founders may want to negotiate up the valuation cap to mitigate against the dilutive impacts potentially coming into effect.

what else did YC change?

The original YC SAFE granted holders a pro-rata right on the next financing round. The new SAFE doesn’t automatically include this. Instead, YC put out a separate side letter on their website under which these additional pro-rata rights might be granted. In NZ, we don’t tend to see pro-rata rights included in convertible notes and SAFEs too often, and founders should discourage their inclusion.

Also, the old SAFE could only ever be amended by the holder. The new SAFE on the other hand permits amendments by written consent from a majority of SAFE holders. This is something we think is valuable on all convertible instruments, i.e. the holders effectively make decisions on a consensus basis, avoiding one single small investor taking a different view holding things up.

other key points to remember about a SAFE

Not specific to the new post money version, but whenever drafting or reviewing a SAFE, keep these tips in mind:

• Look out for most favoured nation (MFN) provisions. These enable early investors to have the benefit of any rights granted to future SAFE holders which might be more beneficial. If nothing else, it can be a burden reissuing new SAFEs on these better terms to lots of prior investors.

• SAFEs typically convert automatically on completion of the next equity financing. There should ideally be no minimum amount to be raised to trigger this automatic conversion under a SAFE.  Some investors like to include a threshold to ensure it is a legitimate fundraising round. Always be careful you do not go too high with this so as to prevent automatic conversion of the SAFE.

• A SAFE (like all convertible instruments) should include language to the effect that, on conversion, holders will only have the benefit of their lower conversion price for the purposes of liquidation preference and anti-dilution rights. This can be achieved through issuing a separate class of “shadow” preferred shares, or just by drafting carefully the relevant provisions in the constitution and shareholders agreement put in place on the equity round.

round up

As SAFEs are not super common in NZ, we’re not proposing to update our template for now to create a post-money version. However, if you are presented with any kind of SAFE right now, it will most likely be the post-money version, so come and have a chat to us.