A Simple Agreement For Future Equity (SAFE) is a ‘simple’ way for founders to raise capital without necessarily pricing the company in the current investment round. A SAFE lets a founder get capital into the business without the usual argy-bargy of trying to work out a valuation. This can be pretty handy in the early stages of a company, when the lack of standard metrics means there’s often a large gap between the value a founder sees in their company, and that of an investor. So the thinking goes: don’t price the round, kick the pricing can down the road until the next funding round (or a future date). This means the parties just need to agree on a discount to the next round and/or a cap on the highest valuation the capital can covert to equity at the next round. That’s the thinking behind using a SAFE.

Except, there are a few unintended consequences of SAFEs which we’ve written about and are well documented elsewhere.

One of the least understood problems is that a SAFE with a cap (and most have caps) is effectively exactly the same as a priced round, with a full ratchet built in.

Most people in this space know enough to know that a full ratchet is hardly seen as a founder friendly provision. Far from it. And for this reason, it’s rare to see a full ratchet on Australian term sheets.

So in order to understand why a SAFE with a cap is like a priced round with a full ratchet, we first need to know how a full ratchet works.

There are a few versions of ratchets. They all serve to re-weight the conversion price of the existing preferred shares if a future round is priced lower than what the investor paid. The old adage ‘you tell me the valuation, I’ll set the terms’ comes into play here. A ratchet allows for a slightly higher price being paid for an investment as there’s an understanding that if things don’t quite work out as forecasted by the founder, then the investor’s holdings will be re-adjusted in light of this.

The most common ratchets look at the amount actually invested in the future round when considering how to re-adjust the investor’s conversion price (broad based, weighted average). Weighted averages in practice typically result in a light re-weight of the conversion price. But the full ratchet will re-adjust the whole investment as if it were made at the future (lower price). Not ideal for founders as it will result in a higher dilution than originally anticipated.

So, why’s a SAFE with a cap the same as a priced round with full ratchet? Well, the cap acts as a proxy for valuation, and the nature of a SAFE means that the equity converts at the cap plus the discount. So in this case, the founder is at risk of having the SAFE convert at a lower price than anticipated if a future round is below the cap. Just like a priced round (at the dap), with a full ratchet.

What are the lessons here? First, if the cap in a SAFE looks about right for a valuation, then it may well be better to invest on a priced round at the cap. This locks in the equity and means any future down-round won’t further dilute the founder more than originally anticipated.