Raising on SAFEs: conversion, dilution and key terms to check

Unlike the US market, where the Y Combinator Post-Money SAFE is the standard, Australia has no single market-standard SAFE. Australian startups raise on a mix of local adaptations of the Y Combinator SAFE, the Australian Investment Council (AIC) SAFE, templates published by VC funds and accelerators, and law firm precedents, in both pre-money and post-money forms. Because many of these documents are simply titled "SAFE" without stating "Pre-Money" or "Post-Money", founders need to check the conversion denominator ("Fully Diluted Capital" or "Company Capitalisation").

If the capitalisation used to calculate the conversion price excludes the SAFE being converted, other SAFEs and convertible notes, it is a pre-money SAFE: each additional converting security dilutes all holders, so a holder’s percentage depends on how much else converts. If that capitalisation includes all converting SAFEs and convertible notes (including the holder’s own conversion shares), it is a post-money SAFE: where there is a valuation cap, each post-money SAFE holder locks in at least a fixed percentage of the company immediately before the priced round’s new money (purchase amount / post-money cap), subject to how the form treats the option pool, meaning additional SAFEs and notes do not dilute other capped post-money SAFE holders, as they dilute existing shareholders (and any pre-money SAFE holders) instead. Under forms such as the current AIC SAFE and the YC post-money SAFE, the holder receives a larger percentage if the round price per share, less any discount, is lower than the cap price per share. Some Australian VCs prefer post-money SAFEs because everyone's ownership is clear without needing to calculate how multiple SAFE tranches dilute one another.

For example, a $500,000 investment on a $5 million post-money valuation cap entitles that investor to at least 10% of the pre-round company (exactly 10% if the cap price per share is below the round price per share and no discount produces a lower price), before the new money and any ESOP pool top-up dilute all shareholders, including the SAFE holder. A low cap can also anchor expectations for the next round's pricing, and stacked caps at different levels make a lead investor's job harder, so it pays to keep the SAFE stack simple, ideally with one cap or a clear step-up.

When a SAFE includes both a valuation cap and a discount rate (typically 10% to 25%, with 20% most common), it converts at whichever mechanic produces the lower price per share for the investor. The Cap Price divides the valuation cap by the SAFE's defined capitalisation base, whereas the Discount Price applies a direct percentage discount to the priced round's share price.

Lead investors commonly require an unallocated Employee Share Option Plan (ESOP) pool of 10% to 15% of the post-round cap table to be created or topped up on a pre-money basis. How that ESOP pool increase affects your SAFE conversion depends on how "Company Capitalisation" is defined in your SAFE.

Under a standard post-money SAFE, Company Capitalisation excludes the new ESOP pool increase. Founders bear the full dilution from the SAFEs, and the pre-money ESOP pool top-up then dilutes founders and post-money SAFE holders proportionately, unless negotiated otherwise in the term sheet. Under a traditional YC-style pre-money SAFE, the cap denominator includes the new ESOP pool increase (and excludes convertible notes), which lowers the SAFE conversion price, shielding the SAFE holders from the ESOP pool and leaving founders to bear more of it. The current (2023) AIC SAFE is post-money and, like the YC post-money SAFE, excludes the round's pool increase except for options promised beyond the existing pool. Earlier Australian SAFEs, including earlier AIC versions, were often pre-money, so always check which version and definition you are using. Capped convertible notes in Australia also vary on whether the round's ESOP pool top-up is included in or excluded from the cap denominator.

In my experience acting for founders in Seed and Series A rounds, incoming lead investors often raise concerns where there is a large SAFE overhang (particularly when combined with a pre-money pool top-up). A heavy overhang can leave founders over-diluted too early and may prompt the lead investor to seek a lower pre-money valuation or a larger founder-borne pool.

Even though the headline Series A round sells 25% of the company to new cash investors, the $9 million pre-money valuation already includes both the two converting SAFEs (10.7%) and the 10% pre-money ESOP pool top-up. Together, all three reduce founder ownership from 100% to 54.3%. You can test your own numbers in the free SAFE Stack Modeller.

Founders should check whether conversion is triggered by any issue of shares for cash, or only when a Qualifying Equity Financing raises above a minimum dollar floor of new money (excluding converting SAFEs and notes). That threshold cuts both ways: without a minimum raise floor, a small bridge equity top-up can unintentionally convert the entire SAFE stack, whereas if the floor is set too high, the SAFE may not convert automatically on a smaller priced round and the company ends up relying on investor consent or the longstop date. Founders should set the floor at a level they will realistically reach.

While standard US SAFEs have no expiry date, some Australian seed funds and angel syndicates insert an 18 to 24-month longstop date at which the SAFE converts at a default valuation cap (or other agreed price) if no priced round has closed, and founders should check which class of shares it converts into. If the SAFE gives the investor a right to be repaid at the longstop instead of converting, it behaves more like a convertible note. That affects the company's balance sheet and solvency position, so founders should resist it or take advice before agreeing.

Under typical Australian Seed and Series A documents, converting SAFE holders and new equity investors often receive the same class of Preference Shares (under the current AIC SAFE, for example, the SAFE converts into the class with the most favourable terms: the class issued in the priced round, or the class on issue at the time of an exit, with the investor nominating the class if there is a dispute), and some Australian constitutions define the 1x "Preference Amount" by reference to the headline class issue price paid by the new cash investors. Because a capped or discounted SAFE converts at a lower price per share, giving those conversion shares the headline class preference amount gives the SAFE holder a preference greater than the amount they actually invested. On a modest exit, that excess comes out of the proceeds of other shareholders, usually the founders. Dividend and anti-dilution rights tied to the class issue price create the same problem. Founders should check how "Preference Amount" is defined in the SAFE and the Constitution, and negotiate for the constitution adopted at the round to define the Preference Amount (and any dividend and anti-dilution entitlements) by reference to the issue price paid or deemed paid for each share, with conversion shares deemed issued at the conversion price. Adopting or amending the constitution requires a special resolution (s 136(2)) and, if existing class rights are varied, class approval under s 246B.

If an early SAFE includes a Most Favoured Nation (MFN) clause, issuing a later bridge SAFE with a lower valuation cap, a larger discount, or investor-friendly side-letter terms gives the earlier MFN holder the right to elect to adopt those terms. MFN clauses are common, especially (but not only) in uncapped SAFEs, and usually end on conversion.

Similarly, granting every small pre-seed SAFE holder an automatic pro-rata right to participate in the next priced round can crowd out the allocation required by an incoming lead VC. Pro-rata rights are therefore typically restricted to investors meeting a minimum dollar threshold and may be waived or reduced as a condition of the round.

Although a SAFE does not issue shares until conversion, entering into a SAFE commits the company to allot shares in the future. Before signing a SAFE, directors should check the company's Constitution and any existing Shareholders Deed to confirm whether entering into an agreement to issue securities requires a board resolution, shareholder approval, or a written waiver of pre-emptive rights from existing shareholders (including checking whether the pre-emptive provisions extend beyond shares to convertible securities). If a company still runs on the replaceable rules, the statutory pre-emption rule in s 254D applies when shares are issued on conversion. Make sure any waiver obtained at signing expressly covers the future issue of shares on conversion, or that the constitution excludes issues on conversion of convertible securities from pre-emptive rights.

Because no shares are issued at signing, a SAFE is not recorded on the register of members or lodged with ASIC until conversion, when a Form 484 must be lodged within 28 days of the share issue. Founders still need to maintain a SAFE register, consider whether the SAFE must be entered in the statutory register of option holders (s 170), and show SAFEs on a fully diluted basis in the cap table, as investors look for these in due diligence.

When a startup raises a priced Seed or Series A round, the incoming lead VC will typically require every converting SAFE holder to sign a Deed of Accession to the new Shareholders Deed as a condition precedent to completion. Company-side SAFEs should include an express investor obligation to accede to the round's Shareholders Deed on conversion. This obligation should be backed by an irrevocable power of attorney, given to secure performance of the investor's obligations, appointing the company and each of its directors from time to time to sign the Deed of Accession and any share application if the investor does not (for example, if an early angel investor is unreachable when the round closes). The SAFE should be executed as a deed (note that the standard AIC SAFE template is drafted as an agreement executed under s 127(1), and its accession clauses, cl 3(d) and 4(f), do not include a power of attorney, so adding both strengthens the company's position).

SAFEs are generally treated as securities for Chapter 6D purposes, as a right or option to acquire shares by way of issue (s 92(3)) (confirm characterisation for your specific instrument). A proprietary company must not make offers that would need a disclosure document (s 113(3), except offers of shares and options over shares to existing shareholders or employees, or a crowd-sourced funding offer), so every SAFE offer received in Australia must fall within a disclosure exemption under section 708 of the Corporations Act 2001 (Cth) when made, and conversion into shares must keep the company at or below the 50 non-employee shareholder limit under section 113(1). The common view is that Chapter 6D disclosure is tested when the offer is made at signing, and that issuing shares automatically under an existing binding SAFE is not a new offer. Where an investor relied on a s 708(8)(c) certificate (given by a qualified accountant no more than 2 years before the offer), some companies take a cautious approach and request updated evidence at conversion if the certificate has since expired. In addition, if shares from a conversion are sold within 12 months of issue, the on-sale rules (s 707) may apply. Offers received outside Australia generally fall outside Chapter 6D (subject to local foreign securities laws), though overseas investors still count towards the 50 non-employee shareholder limit (s 113(1)) on conversion. Founders using the AIC SAFE should also check clause 9, which prohibits conversion if issuing the shares would require a Chapter 6D disclosure document or bring the company under the Chapter 6 takeover rules (which apply to an unlisted company with more than 50 members in total under s 606, counting employee shareholders, unlike s 113(2)) and instead requires the company to repay the Purchase Amount in cash within 5 Business Days.