YC's Secret SAFE

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’s standard deal is 7% for $125K, plus a $375K MFN SAFE and pro rata rights:

• In other words, YC provides its startups with $125K in cash for 7% fixed ownership, implying an effective post-money valuation cap of $1.78M, plus an additional $375K that will convert at the next lowest priced convertible.

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.

The Data on SAFEs vs. Notes

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

SAFEs Dominate Pre-Seed

Here's why nearly 90% of all pre-seed dollars were closed on SAFEs in Q4 2023:

• Stage-Specific: While SAFEs had 89% of the total amount of pre-seed dollars, SAFEs were also used in 50% of all financings at seed (including equity)

• SAFE-Specific: The vast majority (80%) of these agreements were on post-money SAFEs with a cap, which is the Standard YC Post-Money Form.
• 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.

But Convertible Notes Are Heating Up ??

Q: How common are SAFEs vs. Convertible Notes in Other Stages in 2024?

The domination of SAFEs depends on what stage of financing we’re looking at. Capital has a cost, and Aumni’s data from Q4 2023 shows that notes are fueling that cost of capital—75% of convertible financings were done on Notes:

Synthesizing the Data

Q: How can we reconcile the contradictory data sets from Carta and Aumni?

Aumni’s chart showed all venture stages, while Carta’s chart was filtered for 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 VC financing rounds (Series A - D+).

Investors preferences begin to shift from SAFEs to Convertible Notes at Series A:

Macro Factors At Play

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:

Fundamentals of the SAFE

• 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 the time of a subsequent financing round, merger, or sale.
• At five-pages long, the SAFE was built for fast, high resolution financings.
• Founders can space their rounds instead of squeezing investors into a single finite point in time.
• Negotiations can be deferred to the next priced round for board seats, liquidation preferences, protective provisions, M&A and veto/control rights.

Five Major Differences Between SAFEs and Notes

SAFEs work like convertible notes but with five major differences—SAFEs have:

• no interest rate;
• no maturity date;
• no minimum qualified financing amount;
• “Safe Preferred Stock” issued in the next equity round (Shadow Series); and,
• IRS Code §1202—Qualified Small Business Stock (QSBS)—which is explicitly referenced in the Post-Money Safe.

Shadow Series

Of the five categories listed above, Shadow Series has had the most significant influence on the venture capital industry by standardizing the terms of Preferred Stock. This is evident by looking at the capital structures of Series A charters:

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 liquidation windfall - their preference should match what they paid in cash, $0.80 per share, not the additional $0.20 per share, which is something the investor received for free (and if not dealt with, is called the 'liquidation preference overhang').

When a company raises money using SAFEs, the Safeholder will automatically be issued the same exact stock as the next round of equity investors (that is, the same “rights, privileges, preferences, seniority, liquidation multiple and restrictions”) except for the conversion price (or “Safe price”), which is just the per share price based on the effective discount of what Safeholder paid in cash.

A separate “Shadow Series” of shares is created for the Safeholders. For example, if the lead investor is issued “Series Seed Preferred Stock,” a Safeholder should receive “Series Seed-X Preferred Stock”, where “-X” is the series that matches their cap table conversion, such as "Series Seed-1 Preferred Stock."

In simple terms, Shadow Series is a way to ensure fair treatment for all parties.

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. It avoids a snowball effect.

• For example, if new investors pushed for 2x liquidation preference, with participation rights, Safeholders would receive the same structured stock.

As a result, the market has converged around a common standard: 1x, non-participating preferred stock:

The early-stage market has held relatively firm despite significant down round activity in the VC market last year. The largest effects are contained in late-stages:

Two SAFEs, Five Variants, One Key Difference

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

What is a Pre-Money SAFE?

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.

What is a Post-Money SAFE?

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).

In a priced round, assuming all SAFEs are on a post-money basis, three things usually happen simultaneously but the calculations are ordered specifically:

1. All Safes and other convertible instruments convert into “Safe Preferred Stock” (e.g., Shadow Series, such as Series Seed-1 Preferred Stock);
2. An option pool is created or increased after the SAFEs convert;
3. New money is invested in the company at the price per share [PPS] of the preferred stock sold in the equity round.

Immediately after Step #1, SAFEs will convert. Assuming the valuation cap applies, the investor will now 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 the new money from equity holders).

This is visualized by looking at the "X" in the chart, bottom right, below:

Five Variants of (the Post-Money) SAFE

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

1. Valuation Cap Only, no Discount (55%)
2. Cap and Discount* (32%)
3. Discount Only, no Cap (9%)
4. MFN, no Cap, no Discount (4%)
5. Conversion Safe (YC’s Secret Safe) (<1%)

YC quietly discontinued its Cap & Discount Post-Money SAFE in 2021, but the Internet never forgets.

The One Key Difference

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.

• Pre-Money SAFE “Company Capitalization”:

• Post-Money SAFE “Company Capitalization”

• 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:

• Pre-Money SAFE: The pre-money SAFE includes the option pool expansion but excludes all “SAFEs, convertible notes and other similar convertibles.”

• Post-Money SAFE: A post-money SAFE essentially sets a fixed ownership percentage for the investor, but a pre-money SAFE does not.

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

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

• When dealing with Post-Money SAFEs on a Valuation Cap and a Discount, the Discount applies even after the Pre-Money Valuation at the next equity round reaches the Valuation Cap, up to a point (highlighted in yellow):

Discounts can act as minimum price protection for Safeholders at the next equity round up to the point where the cap applies. But this is counterintuitive.

• Generally, the discount applies to the pre-money valuation of the equity round, giving investors a lower conversion price per share. The valuation cap sets the maximum effective valuation at which their investment can convert into equity. Investors will benefit from whichever results in a lower conversion price – the cap or the discount.
• The discount operates as a basement price because investors will benefit from whichever results in a lower conversion price – the cap or the discount.
• This is counterintuitive because the Discount will apply to the Pre-Money Valuation until the Valuation Cap is greater than $X:

$X = Valuation Cap / Discount Rate

Note: This only applies to a SAFE with a CAP & DISCOUNT, not to a Discount only.

Example: $10M Valuation Cap & 20% Discount SAFE with $12M pre-money valuation at the Seed round. Which Safe Price applies - $10M Cap or the 20% Discount?

Discount Rate: 1-0.20 = 80%;

$X = $10M / 0.80 = $12.5M ?

Because $12.5M > $12M we apply the Discount. An odd result!

In other words, the discount would provide a conversion at 80% of the $12M valuation, which is $9.6M. Since the valuation cap is $10M and the effective valuation with the discount is $9.6M, the discount would indeed provide a better (lower) price for the investors, and therefore, the discount would apply.

How the YC SAFE Works (Conversion Percentage)

The formula to convert the YC SAFE with a Conversion Percentage (link) is essentially the same formula as the Standard Post-Money Valuation Cap:

Conversion Percentage * Company Capitalization = Shares of Safe Preferred Stock

As stated earlier, the “Company Capitalization” is the total number of shares in the company at the time of conversion, which calculates all SAFEs before counting the new equity shares, such as the Series Seed or Series A Preferred.

For example, if our 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 the Standard Post-Money Valuation Cap implies the ownership % automatically, calculated by dividing the Amount Raised by the Valuation Cap:

• Amount Raised / Valuation Cap = Implied Ownership %

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

In other words, we see a mirror image between the Standard Post-Money Valuation Cap and the YC SAFE.

Why Should We Use the YC SAFE (Conversion Percentage)?

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 know what to ask for in the 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 any discount.

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.

What Are Some Problems with the YC SAFE (Conversion %)?

There are at least three potential issues with using the YC SAFE form:

1. The conversion percentage is technically more founder-friendly compared to a post-money valuation cap, which represents a minimum ownership percentage. But the trade off for certainty with a fixed ownership percentage seems worth it.
2. The second issue with the YC SAFE is its low acceptance rate will probably not make it worth trying to explain to founders. Even if this form is more founder-friendly, the only way this instrument gets mass adoption is if YC makes it official. YC should release their form to the public, it would be a public good!
3. Finally, this new form disrupts the amendment process in §5(a) because it’s technically a different type of Safe without a valuation cap or a discount:

Conclusion

What if we simplified the SAFE? Scrap the Cap, the Discount, and the MFN and replace those terms with one simple metric: the Conversion Percentage.

Valuation caps are proxies for the truth. Ownership matters. Instead of haggling over a valuation float or a discount, 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.

FOOTNOTES

*You can access the latest YC documents here:

• YC Startup Documents.

YC Post-Money Safe User Guide:

• Safe User Guide.

There are four versions of the Pre-Money SAFE.

• Pre-Money Safe: Valuation Cap, no Discount.
• Pre-Money Safe: Valuation Cap and Discount.
• Pre-Money Safe: Discount, no Valuation Cap.
• Pre-Money Safe: MFN, no Valuation Cap, no Discount.

There are five versions of the Post-Money SAFE, plus an optional side letter.

• Post-Money Safe: Valuation Cap, no Discount.
• *Post-Money Safe: Valuation Cap and Discount (officially discontinued it in 2021). ??
• Post-Money Safe: Discount, no Valuation Cap.
• Post-Money Safe: MFN, no Valuation Cap, no Discount.
• Post-Money Safe: Conversion Percentage.
• Pro Rata Side Letter.