Y Combinator Releases New "Post-Money" Forms of Safes
By Yoichiro “Yokum” Taku and Andrew Sparks
In late September 2018, Y Combinator released new forms of Simple Agreements for Future Equity (“Safes”) containing significant changes to the original forms released in late 2013. In its issuing release, Y Combinator cited a changed funding environment where founders were increasingly using Safes to raise entire standalone rounds of financing, rather than “bridges” into later priced rounds. While the first Safes were intended as quick and easy mechanisms for early stage companies to raise small amounts of money with less friction than convertible notes or preferred stock, Safes are now frequently used to raise large amounts of capital in one or more tranches.
To address the current de facto usage of Safes, Y Combinator has provided updated “post-money” forms. The most significant change in the forms is that Safe holder ownership will now be measured after (post) all of the Safe money is counted, even if there are multiple closings, but still before (pre) the new money in the priced round that causes the conversion of the Safe. A proposed advantage of this formulation is that founders will potentially better understand how much ownership of the company they have sold and what will be their dilution. In addition to this fundamental change on how the Safe conversion is calculated, the new forms contain numerous other changes.
Post-Money Valuation Cap
The new form of Safe provides that the applicable valuation for purposes of calculating the conversion of the Safe is measured after all of the Safe money is counted. The prior form of Safes explicitly excluded Safes and convertible notes in the conversion calculation. In our view, having the valuation cap on a pre-money basis as in the prior form was more consistent with the financial structure of a traditional venture financing. Setting the valuation cap on a post-money basis may create confusion and unintended consequences for founders who take a casual approach to Safes, and this change may actually benefit investors. For example, if the post-money valuation cap is fixed, then every additional dollar taken in under the Safe will dilute the founders and early employees. The circular formulas created by putting the converting securities in the definition of company capitalization (the denominator for purposes of the conversion calculation) may be even more confusing for founders than the prior methodology.
Under the prior form of Safe, if a company had a number of Safes outstanding at various valuation caps, then the denominator for calculating the conversion price should have included the shares converting from lower valuation cap Safes. Similarly and as an example, in a Series A financing, the shares issued in previous financings, such as a Series Seed, would be included in the pre-financing capitalization for calculating the Series A price per share. However, we found that many investors did not necessarily realize this Safe conversion nuance when they invested in a Safe at a higher valuation cap. Moving to the post-money valuation cap Safe will solve this issue and is generally investor-favorable.
While this change has the potential to help founders better understand ownership and dilution, there may initially be some confusion about how much of the company’s future equity they have actually sold, and it may be even more than they anticipated. A potential pitfall for founders to avoid under the new post-money Safes would be to raise too much money under a Safe with a relatively low valuation cap. Founders should consider increasing the valuation cap in response to rising demand; otherwise they will risk ending up with far less of the company’s equity than they had originally intended.
Exclusion of Option Pool Expansion
The option pool expansion in the financing is now excluded from the denominator in calculating the Safe conversion. Removing the option pool increase in a financing from the denominator is founder favorable, but we think this is conceptually fair if the form is moving to a post-money valuation cap. This change may help offset the shift to the new post-money conversion calculation. In the prior form of Safe, the entirety of the option pool increase in the new financing (i.e., the Series A) was included in the denominator, and this was possibly a bit too investor favorable. If one were to mimic a preferred stock financing, the option pool that should be in the denominator would be the size of the pool that would have been agreed to at the time of the Safe. However, if the pool is unused prior to the next round, then the investor gets a windfall.
Priority in a Dissolution
The form now clarifies that the Safes are junior in priority to any debt, including convertible notes, upon a dissolution or liquidity event. The Safes are stated as being on parity with other Safes and preferred stock, but still senior to the common stock. We feel that the liquidation priority clarification is a helpful change based on past situations where it was less clear how a Safe should be treated, particularly in a dissolution where there may have been many obligations to general creditors, debt holders, and holders of preferred stock. The new language is helpful in removing the ambiguity that the Safes are junior to all of the company’s debt.
New Tax Language
The new form includes certain tax-related provisions at the end. These provisions are primarily intended to, among other purposes, (a) support the position that the instrument would be treated as stock as of the time of its issuance for tax purposes, including for qualified small business stock purposes, and (b) help avoid certain phantom income on certain equity interests in a corporation akin to original issue discount on certain debt instruments.
Safes have historically provided that they could only be amended or changed by the written consent of both the company and the individual Safe investor. This often led to situations where companies had to track down signatures from multiple individual investors and any one particular investor could hold up a financing. In the new forms, there is now a mechanism, similar to that found in convertible notes or traditional venture financing documents, which provides that the Safes may be amended by the company and a majority of the Safe holders with the same valuation cap and discount rate. There is language in the provision that the investment amount may not be changed unless all Safe investors should have their consent solicited (i.e., receive notice) and that the amendment has to treat all Safe holders in the same manner. This new amendment provision makes it easier for the company to make changes to the Safe if there is one stubborn holdout investor blocking a conversion event. On the other hand, investors will want to be cautious if they are a smaller investor in a large Safe round and should know that their Safe could be amended without their consent.
No Changes Acknowledgement
The new forms now contain an acknowledgment at the beginning of the form that neither of the parties has modified the forms except to fill in the blanks. We like this change because parties often make revisions to Safes without necessarily identifying the changes, which often led to confusion on the part of founders, investors, and their lawyers. This acknowledgment should help put everyone on the same playing field. To the extent either party wanted to make changes to the Safe, they would need to delete this language, which would help signal to readers that there will be changes to be aware of in the Safe.
Pro Rata Rights Side Letter
Y Combinator has contemporaneously issued a new optional form of standardized pro rata rights side letter for the financing that causes the conversion of the Safe. The prior form of Safe provided that investors would get pro rata rights, but only after the Safe had converted. In other words, a Safe investor wouldn’t have pro rata rights in the Series A, but they would have it in the Series B. The new form of side letter provides a simple way for Safe investors to insure they have pro rata rights in the company’s first equity financing. One of our main concerns about the prior Safe forms was that they did not contain this type of pro rata right, especially where large Series A rounds could be highly dilutive to existing Safe investors, so we feel that this side letter is a helpful tool for investors in guaranteeing meaningful pro rata rights in a Series A (or Series Seed) financing.
On a practical level, founders and investors should be aware of these changes made to Y Combinator’s Safes and should continue to consult with their legal counsel when issuing securities.
For more information, please contact Yoichiro Taku, Andrew Sparks, or any member of the corporate law practice at Wilson Sonsini Goodrich & Rosati. Thank you to our colleagues in our tax practice for their valuable contributions to this memorandum.
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