The SAFE Trap: Why This Fundraising Tool Can Backfire for Startups

Recent data from Carta's First Cut—State of Private Markets: Q2 2024 reveals that SAFEs (Simple Agreements for Future Equity) dominate early-stage startup funding, with over 89% of pre-seed funding utilizing these instruments. While SAFEs have become the go-to choice for many founders, offering a seemingly simple solution to early-stage fundraising challenges, they can create unexpected complications as startups grow. Let's dive into why these popular agreements might turn into a headache when it's time for the next funding round, and how to navigate the potential pitfalls.

Key Statistics on SAFE Usage and Valuations

• In Q4 2023, SAFEs accounted for 89% of all funding and 85% of all signed notes for pre-seed rounds.
• About 80% of SAFEs used were post-money (the Y Combinator default), while 20% were pre-money (more favorable to founders).
• SAFEs made up over 90% of fundraising in SaaS, Fintech, Gaming, and Edtech sectors.
• Industries still using Convertible Notes significantly include Medical Devices, Pharma/Biotech (30%+ of funding), and Hardware (about 25%).
• Seed round valuations on SAFEs increased from $13M to $14M, while priced Seed valuations rose from $12.6M to $14.1M, approaching all-time highs.

What Makes SAFEs So Complicated?

When Y Combinator rolled out SAFEs in 2013, the goal was to simplify early-stage fundraising. No valuation disputes, no debt complications — just a clean, straightforward promise of future equity. The startup world was hooked. But fast forward to today, and many founders have found that these “simple” agreements can cause some serious problems down the line. Here’s why:

1. Dilution Disaster: SAFEs convert to equity at the time of a priced round, typically with terms like discounts or valuation caps. This sounds great on paper, but if you’ve got multiple SAFEs with different terms, you’re in for a headache. Converting SAFEs can lead to unexpected dilution for existing shareholders, and new investors in your Series A or B are going to want to know exactly how much of the company they’re buying into. With a bunch of SAFEs converting at different rates, that’s easier said than done.
2. Valuation Cap Confusion: SAFEs often come with a valuation cap — the maximum price at which they convert to equity. If your new round values the company above this cap, early SAFE investors convert at a lower price, scooping up more shares and creating more dilution for everyone else. This isn’t just a minor inconvenience; it’s a big problem that can scare off new investors, who might feel like they’re paying a premium while earlier investors get a better deal.
3. Discount Drama: Many SAFEs offer discounts on the price per share in the next round, which can stack up quickly. Different SAFEs with different discounts can lead to a waterfall of conversions that makes it tough to figure out the final cap table. This uncertainty can give pause to new investors who crave clarity and stability in their investments.
4. Rights and Preferences Roulette: SAFEs usually don’t come with traditional investor rights like voting power or board seats. But as they convert, these rights can come into play, especially if the new round includes preferred shares with specific protections. Aligning these rights among all investors — old and new — can turn into a legal and logistical nightmare.

How to Manage the SAFE Chaos

To keep your cap table clean and your investors happy, consider these strategies:

1. Be Transparent Early and Often: Don’t wait for a potential investor to ask about your SAFEs. Be proactive. Lay out all the possible scenarios for SAFE conversion and its impact on the cap table. The more upfront you are, the less likely you are to scare off potential investors when they realize the extent of the dilution.
2. Leverage Cap Table Management Tools: Use advanced cap table management software to simulate different SAFE conversion scenarios. These tools can help you and your investors see the potential outcomes and understand exactly what’s at stake. Clarity is key — the more predictable you can make the future, the better.
3. Consider Pre-emptive Action: If you have the runway, think about converting your SAFEs to equity before you start a new funding round. Alternatively, if cash flow allows, buying them out might simplify things even more. This can make your startup more attractive to new investors who want to see a straightforward, predictable cap table.
4. Standardize Terms Across SAFEs: If you’re issuing multiple SAFEs, try to keep the terms consistent — same valuation caps, discounts, and conversion mechanics. The more uniform your SAFEs, the less messy the conversions will be when the time comes.
5. Get the Right Advisors on Board: Navigating SAFEs isn’t just a numbers game; it’s also about understanding the legal and financial implications. Work with experienced advisors who can help you set up terms that won’t come back to haunt you in future rounds.

The Takeaway: SAFEs Aren’t Always Simple

While SAFEs were a game-changer in startup financing, making it easier for companies to raise early funds, they come with a set of complications that can’t be ignored as your company grows. As you move from seed funding to Series A, B, and beyond, those early agreements could complicate things in ways you never anticipated.

Don’t let the “simple” in SAFE fool you. Make sure you’re thinking ahead, planning for the complexities, and keeping your cap table as clean and straightforward as possible. After all, in the world of startups, what you don’t know (or ignore) can hurt you — especially when it comes to fundraising.