Tl;dr: SAFE pro rata of the Y-combinator post-money SAFE financing document explained line by line explanation.
If you are planning on raising an angel/seed round with a new post-money SAFE you need to know what is in the legal agreement. You aren’t a lawyer, so I’m going to explain the whole document in simple English.
I’m going to cover each of the 5 documents that Y-Combinator offer. If you are going to use another one, you can link to the right blog here:
- Safe: Valuation Cap, no Discount
- Safe: Discount, no Valuation Cap
- Safe: Valuation Cap and Discount
- Safe: MFN, no Valuation Cap, no Discount
- Pro Rata Side Letter
All quotes are the exact wording of the SAFE documents. Everything else is my comments. For idiots, this is not legal advice, I take no responsibility for any losses, get a lawyer, yadda yadda.
For syntax, I’m going to assume you raise at a series-A. That’s the word for the qualified financing round I am going to use.
Note: there are a number of places where there are numbers involved. I’m not going to nerd out here on how the math is done. Instead, I made a model with the math done. Download the model and you can see how the math is done. You can read the blog here.
Download the SAFE model
You need to input your legal name. It’s one of only 3 fields other than signature stuff you need to fill in.
Introduction section on the SAFE pro rata agreement
This agreement (this “Agreement”) is entered into on or about [Date of Safe] in connection with the purchase by [Investor Name] (the “Investor”) of that certain simple agreement for future equity with a “Post-Money Valuation Cap” (the “Investor’s Safe”) issued by [Company Name] (the “Company”) on or about the date of this Agreement. As a material inducement to the Investor’s investment, the Company agrees to the provisions set forth in this Agreement. Capitalized terms used herein shall have the meanings set forth in the Investor’s Safe.
This section basically says it’s a side letter to the SAFE that you signed.
You need to input:
- The date you are signing this document and it comes into effect. E.g. 1 January 2020
- The investor name. E.g. Sequoia
- Your company name. E.g. Uber
Note, this looks like an oversight “of that certain simple agreement for future equity with a “Post-Money Valuation Cap””. You will need to hire a lawyer to change this if you are doing a note with a discount, or a discount and a cap. The SAFE guide is only written with a cap, so my guess is they have a bias for cap only documents. I presume they don’t want to make a template for each document.
So the other parts of this section are:
- Material inducement: Getting a pro rata is a reason the investor is investing in the SAFE
- Company agrees: There are new terms in this agreement that the founders agree to
- Capitalized terms: You need to read this document alongside with the SAFE that you signed with the investor
SAFE pro rata rights explained
The Investor shall have the right to purchase its pro rata share of Standard Preferred Stock being sold in the Equity Financing (the “Pro Rata Right”). Pro rata share for purposes of this Pro Rata Right is the ratio of (x) the number of shares of Capital Stock issued from the conversion of all of the Investor’s Safes with a “Post-Money Valuation Cap” to (y) the Company Capitalization. The Pro Rata Right described above shall automatically terminate upon the earlier of (i) the initial closing of the Equity Financing; (ii) immediately prior to the closing of a Liquidity Event; or (iii) immediately prior to the Dissolution Event.
This is the meat of the document. Pro rata rights mean that an investor can maintain their ownership percentage. If they buy 10% (however the calculation ends up working) then in this round of finance if they get diluted by the series-a investor and the new ESOP increase than they can invest more money and keep the total diluted ownership at 10%.
Investors will only use their pro rata if:
- They have the money to invest more money to cover the pro rata
- You are hot and they want to own more of you
There are typically two types of stock in the SAFE docs (the discount version only has one kind). These are:
- Safe Preferred Stock: This is normally what the SAFE investor gets (It has a few different terms related to prices for liquidation preference)
- Standard Preferred Stock: This is the same that the series-a investor gets
With the pro rata, the SAFE investor gets Safe Preferred Stock when the Equity Financing happens (This is defined in the SAFE document).
They then define how the calculation of the pro rata works under the cap scenario. This is:
- The shares the investor has from conversion under a cap, divided by
- The Company Capitalisation
“Company Capitalization” in the cap only version is calculated as of immediately prior to the Equity Financing and (without double-counting):
- Includes all shares of Capital Stock issued and outstanding;
- Includes all Converting Securities;
- Includes all (i) issued and outstanding Options and (ii) Promised Options;
- Includes the Unissued Option Pool; and
- Excludes, notwithstanding the foregoing, any increases to the Unissued Option Pool (except to the extent necessary to cover Promised Options that exceed the Unissued Option Pool) in connection with the Equity Financing.
This gives you ownership %. So if they get 1m shares and the capitalization is 10m, they own 10%. That’s the pro rata they can maintain at the series-a (Note that in the old pre money notes, the pro rata only applied in the next round of financing, not in the round in which they converted.
The final part of this clause is regarding how and when the note is terminated (deleted):
- (i) the initial closing of the Equity Financing: They convert before the series-a, so they get diluted by the ESOP increase and the series-a amount
- (ii) immediately prior to the closing of a Liquidity Event: If you sell the company or IPO, the SAFE gets their money back, or their share if they converted into stock (whatever is higher)
- (iii) immediately prior to the Dissolution Event: They get up to their money back if you shut the company down
Can’t sell the SAFE pro rata rights on
Neither this Agreement nor the rights contained herein may be assigned, by operation of law or otherwise, by Investor without the prior written consent of the Company; provided, however, that this Agreement and/or the rights contained herein may be assigned without the Company’s consent by the Investor to any other entity who directly or indirectly, controls, is controlled by or is under common control with the Investor, including, without limitation, any general partner, managing member, officer or director of the Investor, or any venture capital fund now or hereafter existing which is controlled by one or more general partners or managing members of, or shares the same management company with, the Investor.
The investor can not sell on their pro rata rights to anyone without your permission. They can, however, move the rights around under their company structure and between directors. So if say Jim is a partner that did the deal, but he quits and Mary takes over, she can still control the investment.
Pro rata rights have value if your company is hot.
SAFE pro rata document can be changed
Any provision of this Agreement may be amended, waived or modified upon the written consent of the Company and either (i) the holders of a majority of shares of Capital Stock issued from all Safes converted in connection with the Equity Financing held by the Investor and other Safe holders with Pro Rata Rights pursuant to agreements on the same form as this Agreement (available at https://ycombinator.com/documents), provided that such amendment, waiver or modification treats all such holders in the same manner, or (ii) the Investor. The Company will promptly notify the Investor of any amendment, waiver or modification that the Investor did not consent to. This Agreement is the form available at https://ycombinator.com/documents and the Company and the Investor agree that neither one has modified the form, except to fill in blanks and bracketed terms. The choice of law governing any dispute or claim arising out of or in connection with this Agreement shall be consistent with that set forth in the Investor’s Safe.
If the company is happy to change the document it can be, but this also requires investor approval.
The investor approval is defined as:
- The majority of all SAFE holders if their SAFE and pro rata converted into shares and they are all treated the same. This means the investor can be dragged along to change their agreement if most people say so
- The investor who holds this SAFE pro rata side letter. Basically, they can choose to change their own terms if they and the founders like
Next, they say that if changes are made (presumably under point 1) which the investor of this document originally did not agree to, that they lost the vote and their document is now different.
Next, they say this document is as it is on the website and you can’t change anything that wasn’t in a bracket. This doesn’t really make sense since I don’t see why there wouldn’t be a pro rata under the cases of a discount and a discount and cap. I presume if you hired a lawyer to change this document you would also delete this section.
Finally, where the note is governed is as per the SAFE that was signed.
IN WITNESS WHEREOF, the undersigned have caused this Agreement to be duly executed and delivered.
You and the SAFE investor put in your details. Easy, duh.
Conclusion on the SAFE pro rata
The SAFE pro rata is a relatively short document. There is not much that you need to understand. You just need to decide if you are going to give pro rata rights to a SAFE investor. You typically would only give the pro rata rights to majority investors (those that invest in the majority of the round you are doing) and that you want to be on your cap table for a long period of time. This is more often institutional investors.
The template side-letter here is only for the cap only version of the SAFE templates. If you want the pro rata to apply, you will need to hire a lawyer to adjust the terms (and remove the part which says the docs are as per y-combinators website).