SAFEs (Simple Agreements for Future Equity), and other regional variants of the SAFE, have surged in popularity in recent years. These financial tools streamline the fundraising process by skipping over a lot of the complexity of a priced round, in the terms and conditions, thereby accelerating capital acquisition for founders.
A pivotal feature of SAFEs is their ability to incentivise early investors through mechanisms like valuation caps or discounts. These features determine the conversion rate of the SAFE into equity upon a subsequent priced round, and are designed to reward early investors for the additional risk they have taken by committing earlier.
Understanding when to deploy a valuation cap versus a discount is crucial for both entrepreneurs and their investors. Each mechanism has its strategic implications. You can read more about both terms, the logic behind them, and other aspects of using convertible instruments like SAFEs, in our deep-dive article: “SAFE Caps and Discounts: Setting the right terms for your round”
In this article, we explore the role of the discount, how it works in practice, and a recommend approach to setting the right discount rate if you choose to pursue financing on a SAFE. For perspective on when and how to use a discount instead, we have a similar article available here.
The purpose of a SAFE discount
A valuation discount is a coefficient that is applied to the future priced round valuation.
For example, if you were to take a Pre-Seed investment via a SAFE with a 20% discount, and then go on to raise your Seed round at $15M pre, the SAFE investment would convert to equity at $12M based on the discount.
When to use a discount, rather than a cap
Valuation discounts, on the other hand, work on the assumption that you can’t easily predict anything about the future. You may not know when the priced round will be, or how much progress you will have made by that point. You are asking investors to wait and see what those terms look like.
As opposed to setting a cap, discounts are most appropriate for startups with front-loaded risk and uncertainty, such as hardware, biotech or deeptech.
The typical approach to setting SAFE discounts
A standard discount might range from 10% to 30%, ensuring that early investors receive shares at a lower price than those who invest in later rounds. The discount incentivizes early investment while still aligning the interests of the investors and the founders by not excessively diluting the startup’s equity base. It’s important to keep in mind that the typical SAFE discount is ‘flat’, applying at the point of conversion with no change in rate over time, and is almost always used in combination with a cap — in contradiction to Y Combinator’s standard documents.
To determine an appropriate discount for a SAFE, investors and founders often consider the following:
- Stage of Investment: The earlier the stage of investment, the higher the discount might be. For example, pre-seed or seed-stage investments typically come with a higher discount (e.g., 20-30%) due to the increased risk, whereas later-stage investments might have lower discounts (e.g., 10-20%).
- Risk Perception: If the startup is perceived as high-risk, investors may seek a higher discount to compensate for the uncertainty. Conversely, if the startup has demonstrated significant traction or has a clear path to revenue, a lower discount might be more appropriate.
- Market Conditions: In a competitive fundraising environment where many startups are seeking capital, investors might accept a lower discount to secure a deal. Conversely, in a market where capital is scarce, investors might push for a higher discount.
- Investor Leverage and Negotiation: The discount rate is often a point of negotiation. If investors have strong leverage (e.g., if they are bringing significant strategic value or capital), they might negotiate for a higher discount. Conversely, if the startup has multiple interested investors, founders might be able to negotiate a lower discount.
- Standard Market Practice: Both parties often look at what is standard or typical in the market for similar deals. SAFE discounts commonly range from 10% to 30%, and aligning with these norms can help ensure that the terms are seen as fair and reasonable by all parties involved.
Our recommended approach to SAFE discounts
Given the role of a discount, we recommend looking at the required ROI for venture capital when calculating your discount. This way, you are appropriately compensating investors for the risk and opportunity cost of that capital.
By deferring valuation entirely until that subsequent priced round, and increasing the discount over time, early investors can be confident that whenever you raise the priced round, and at whatever price, they will get appropriately preferential pricing, reflecting the time they’ve had skin in the game that hadn’t yet converted to equity. While this results in a much greater discount than is commonly seen today, keep in mind that this is without a cap.
You can see in the examples below, using the required ROI of 89.12% for ‘Startup stage’ companies, how the discount affects conversion in the case of a startup raising their Series A after a SAFE Seed round of $3.5M:
| $3.5M Seed SAFE | Discount (Required ROI 89.12%) |
|---|
| Time to conversion | 18 Months | 21 Months | 24 Months |
| Total discount | 52.59% | 60.43% | 67.13% |
| Scenario: Median Series A ($45M Valuation) |
| Dilution | 20.23% | 23.65% | 27.78% |
| Adjusted price | $17.3M | $14.8M | $12.6M |
| Scenario: Outlier Series A ($75M Valuation) |
| Dilution | 12.15% | 14.23% | 17.24% |
| Adjusted price | $28.8M | $24.6M | $20.3M |
| Annual Discount: -47.03% |
To model these outcomes yourself, use the following fomula:
= priced round valuation / (( 1 + required ROI) ^ ( number of months * (1/12)))