Origins of Rolling SAFEs

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Blockchain technology has enabled the development of new financial instruments and mechanisms subsumed under the overarching term Decentralized Finance (DeFi). DeFi contrasts with traditional finance as it does not require central, trusted intermediaries for transactions like banks, clearing houses, or centralized exchanges. Instead, smart contracts are used to manage transactions and implement DeFi instruments as the transparent and immutable nature of blockchains negates the need to involve a trusted third party, i.e an intermediary. Cryptocurrencies are the most prominent and basic form of DeFi. The next level of complexity is tokenization, where the token is a digital representation of ownership, be it a share in a company, a valuable asset, or physical good like an artwork or a house.

Startups in the blockchain space use the technology to help raise capital and fund their business growth. Hence the proliferation of initial coin offerings (ICOs) was followed by security token offerings (STOs) and a number of other asset-raising ideas. The majority of blockchain-based asset "offerings" partially mirrored initial public offerings (IPOs) in traditional financial markets, where companies "go public" and list their stock on exchanges, creating public equity. There are many significant differences between IPOs and even the most respectable ICOs, including questions of regulation and ownership, but that is a discussion for another time.

A great deal of early funding for blockchain startups still comes through the same route as for other non-blockchain startups: private equity. In the very early stages, investment often comes from friends and family, and so-called angel investors. As the company matures, the founders may look to professional investors at venture capital firms and funds as a source of capital. All these types of investment are predominantly exchanged for equity in a company, i.e. a representation of the value of the investor's stake by owning a portion of a company's shares.

The early-stage funding phase of seed rounds and more formal venture capital funding series is ripe for innovation and disruption. The Rolling Simple Agreement for Future Equity (Rolling SAFE) is such a blockchain-based innovation, focused primarily on early funding for a startup. The seeding round is typically the very first time an entrepreneur will look externally to fund their new project.

The origin of Rolling SAFEs: A Simple Agreement for Future Equity

A Simple Agreement for Future Equity (SAFE) was designed as a more simple replacement for convertible notes. A simple agreement for future equity (SAFE) can be defined as an agreement between a company/the issuer and investors providing the latter with rights to the company's future equity. A SAFE is a convertible security: an investor provides a company with funding to in the future be able to convert their investment into ownership in the company.

See the expandable box above for an explanation of convertible notes.

When an investor invests in a company using a SAFE, they exchange their capital for the right to future equity in the company at a triggering event - both SAFEs and convertible notes are also used for later-stage bridge finance, but that is not relevant in this context.

Similar to convertible notes, a SAFE postpones the problem of company valuation until a later date when the equity is transferred to the investor at the triggering event. Valuing a company at a very early stage is difficult, especially if it is just some founders, an idea, and a business plan. Postponing the valuation until there are more data points is a logical way to solve the problem.

Let us get triggering events out of the way. A triggering event is normally either when a priced round of investment occurs, like a series A round, or a liquidity event occurs, like the company getting bought by a competitor. The key is that the event includes the striking of a price. If the company is in a position to raise funds in a formal series round, there must be some consensus on the company valuation. The same applies if the company is bought. As we now have a consensus on the company valuation and with it the price, the SAFE can convert to equity or be bought out at an agreed rate.

SAFEs were created by Y Combinator in 2013 to simplify the early-stage asset-raising process. The SAFE was a short document with little space for negotiation other than key areas that were set out. SAFEs have evolved since 2013 and can now have almost as many moving parts as a convertible note. However, certain differences between both remain true:

A SAFE is not a debt instrument, the company does not need to pay back the principal, and it does not accrue interest;
A SAFE does not have a maturity date, meaning there is no need to arrange extensions if the triggering event has not been reached.

The key, most common areas for negotiation in a SAFE are the discount rate, the valuation cap, pro-rata rights, and the Most Favoured Nation clause. A SAFE can have a combination of any of them or all of them:

Discount rate: The discount the investor receives relative to investors in a subsequent financing round, usually series A. This discount compensates the investor for taking on the risk of investing early. For example, if a series A investor can buy a share for $10, the SAFE holder with a discount rate of 20% would be able to convert their investment at the equivalent value of $8 a share. Discount rates can be anything from 10% to 30% or occasionally more, most often they are around 20%;
Valuation cap: Effectively caps the price at which an investor will convert their SAFE. In the example above, if the SAFE had the equivalent of a $5-a-share cap, that would be the conversion price, instead of $8 at a 20% discount rate. If a SAFE has both a valuation cap and a discount rate, the investor can choose which to exercise. Logically an investor will choose the lowest price. Valuation caps are usually quoted as the valuation of the whole company than on a share-by-share basis. To extend the example above, the SAFE could have a valuation cap of $5 million with the company having a pre-money valuation of $10 million;
Pro-rata rights, or participation rights: Allow the investor to invest additional funds to maintain their ownership percentage during rounds after their equity was converted. To again extend the example above, the company decides to do another financing round in a series B. The investor converted at $5 a share in series A because of the valuation cap. The SAFE now allows investors to buy more shares in series B at the series B price, let us say at $15, up to an amount that keeps their ownership of the company at the same percentage - this was an automatic clause in the original 2013 SAFEs, but is now more commonly a negotiated side note;
Most favored nation clause (MFN): An MFN simply means that no other investor can have better terms than the ones set out in the SAFE with the MFN clause. They can have the same terms, just not better (e.g. a lower valuation cap or higher discount rate). This rewards the original SAFE investor for taking an early risk - MFN clauses can not be applied retroactively, i.e. a series B investor cannot ask for an MFN clause that affects a series A investor.

The original SAFEs conceived in 2013 were formally updated by Y Combinator in 2018. Admittedly, SAFEs are an open resource so they have been modified extensively over time. The new versions created in the update aimed at capturing the most common modifications. When it comes to the size of the return expected by an investor and therefore, the amount given up by the company, the most consequential change was moving the valuation cap from pre-money to post-money. In other words, the pre-money valuation cap was intended to show the value of the company before the SAFE converted to equity, whilst the new SAFEs value the company after the SAFE has been converted, so to say post-money.

The importance of the change from pre- to post-money valuation is best outlined with an example. Let us assume a pre-money valuation cap of $1 million and that the SAFE investors invested $200,000. The post-money valuation would be $1.2 million following the conversion of the SAFE. Using simple math, this SAFE would effectively purchase 16.67% of the company ($200,000.00/$1.2 million).

These conversion percentages are typically a best guess and do not account for other variables that come into play like option pool increases, previous investments using other mechanisms, subsequent SAFEs, etc.

This is straightforward if you only had one investor or if all investors invested at the same time. However, if you have a number of SAFEs, sold at different times, with different valuation caps, it is difficult to work out what an investor's final equity stake will be. Using the same math as above, if an additional $300,000 of SAFEs were issued, the post-money valuation would be $1.5 million. The initial $200,000 would now be worth 13.33% ($200,000/$1.5 million).

In essence, future SAFE purchasers are diluting previous SAFE investors and ultimately defeating one of the core tenants of SAFEs: transparency. Equally, the previous SAFE made it somewhat difficult for new investors to ascertain what they were purchasing and unsure of their ultimate equity percentage.

This problem is simply solved by using a post-money valuation cap. Investors have a much better idea of the outcome of their investment, assuming conversion at the valuation cap and not the discount rate. Investors are less likely to be subject to unanticipated dilution by using a post-money valuation. As an example, using a post-money valuation cap, if the valuation cap was $1 million and an investment of $200,000 was made, the investors now know that this would be equal to 20% ($200,000/$1 million). If a future investor comes in for $300,000, unlike the original example, it would not dilute the first investor.

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