How to Read a Safe Term Sheet
As an entrepreneur seeking funding, you have a variety of term sheet options, including the safe (simple agreement for future equity). Originally created by Y Combinator as an alternative to convertible notes, the safe maintains the flexibility of a convertible note but addresses many of its problems. It does not collect interest or have a maturity date, instead deferring conversations around valuation, liquidation preference, and participation rights to the next round.
We’re seeing more safe term sheets since it’s a quick and simple option in early-stage rounds and the primary recommended vehicle for non-equity rounds in IL in order to receive angel tax credit). In fact, Hyde Park Angels just invested in in artificial intelligence company Motion AI via a safe.
Safes have their advantages and disadvantages, but the first step in deciding whether it’s the right fit for your raise is to understand it. Here’s a quick, skimmable glossary of terms to understand in a safe term sheet. The glossary is built so you can follow along — each term is listed in the order it appears in Y Combinator’s Safe: Cap and Discount term sheet.
Valuation Cap: The maximum valuation investors will convert their investment into equity in the next round.
Discount Rate: The percentage discount investors receive on shares in the next round of financing.
Equity Financing: If and when the company raises the next round as equity, the investor will receive shares equal to their Purchase Amount/Conversion Price
Liquidity Event: In the event that the business exits before the safe expires or is terminated, investors will receive cash payment or stock equal to the shares they purchased. If the company does not have enough funds to pay the full amount, then the company’s available funds will be distributed back to the investors.
Dissolution Event: The closing of the company for reasons other than a liquidity event (i.e. operations shut down).
Termination: The safe will expire and terminate when the company issues the stock back to the investors or the company pays the investors back their investment amount.
Capital Stock: The company’s common and preferred stock.
Change of Control: This occurs when the company, whether through a sale, transference of stock, or merger changes ownership.
Company Capitalization: Capital Stock (excluding the safe being agreed upon, other safes, and convertible notes) + Common Stock
Conversion Price: Either the Safe Price (Price Per Share = Valuation Cap/Company Capitalization) or Discount Price depending on which yields the most shares for investors.
Discount Price: The price of the shares in the next round of equity financing after the discount rate has been applied. See definition of “discount rate” above.
Distribution: The administration of transferring assets (cash or other property) to those who have Capital Stock in the company.
Liquidity Capitalization: The number of shares of Capital Stock prior to a Liquidity Event of outstanding shares, excluding Common Stock reserved for future grants, the safe being agreed upon, other safes, and convertible notes.
Liquidity Price: Price Per Share = Valuation Cap/Liquidity Capitalization
Pro Rata Rights Agreement: A written agreement that gives investors the right to purchase its pro rata shares in the next equity financing.
Safe Preferred Stock: The shares of preferred stock promised in the future at the point of an equity financing. The rights of this Stock will be identical to the Preferred Stock in the next equity financing other than the special rights outlined in this safe such as discount rate.
Safe Price: Price Per Share = Valuation Cap/Company Capitalization
Standard Preferred Stock: The preferred stock that will be issued at the next equity financing.
This post is part of the Hyde Park Angels Entrepreneurial Education Series, which brings together successful, influential entrepreneurs and investors to teach entrepreneurs everything they need to know about early-stage investment through events, articles, videos, and more. If you are interested in learning more about similar topics, register for “When to Raise Venture Capital or Bootstrap” on March 3.