MFN SAFEs, side letters, and early exits

After the first SAFEs, founders get three new kinds of question. An angel asks for “an MFN.” A fund asks for “pro rata.” And in some cases, a buyer calls before the priced round. This lesson answers all three. Each answer can move a few percent of your company or a few million dollars.

The MFN SAFE

MFN is short for “most favored nation.” An uncapped MFN SAFE has no cap and no discount. But it has an MFN clause: a promise that the holder can get the terms of a subsequent SAFE if those terms are better.

The YC form sets the steps. If the company issues a subsequent SAFE or another convertible security, it sends an “MFN Notice” to the holder. The holder then has 10 days from receipt of the notice to select the new terms. If the holder selects them, the company changes the MFN SAFE to be identical to the subsequent SAFE.

Here is an example. In January, Sam invests $100,000 in Northwind on an MFN SAFE. In March, Northwind issues a $1M SAFE with a $12M post-money cap and no MFN. Sam selects the $12M cap. Sam now owns $100,000 ÷ $12M = 0.833%.

Four rules control the MFN:

• One switch only. After Sam selects the March terms, his SAFE is a copy of the March SAFE. The March SAFE has no MFN, so Sam’s MFN right stops.
• All the terms or none. Sam gets all the terms of the subsequent SAFE, not only the terms that he likes.
• Side letters with no money terms do not count. From version 1.2, a side letter with no economic terms, such as an observer seat or information rights, does not start the MFN.
• The date is the later of two dates. The YC FAQ tells founders that the MFN uses “the later of signing the SAFE or receiving the wire.”

Predict first

Sam selected the $12M cap in March. In May, Northwind issues a SAFE with an $8M post-money cap and no MFN. What is Sam's cap after May?

Type a guess before you continue. A guess first, even a wrong one, makes the answer easier to remember.

Your guessSave my guess

The order of your SAFEs is important

The MFN reaches only the SAFEs that come after the MFN SAFE. Thus, the order in which SAFEs close changes the result. In the widget, move the three SAFEs into a different order. Then answer each MFN Notice for Sam.

Try it

Three SAFEs and one MFN

Sam invests $100K on an uncapped MFN SAFE. Two other SAFEs close in the same months. Set the order, then answer each MFN Notice for Sam.

1. Month 1: Sam

   $100K uncapped MFN SAFE

2. Month 2: Birch Ventures

   $1M SAFE at a $12M post-money cap, no MFN
   Sam's answer to the MFN Notice

   Keep the MFNSelect terms

3. Month 3: Cedar Angels

   $250K SAFE at an $8M post-money cap, no MFN
   Sam's answer to the MFN Notice

   Keep the MFNSelect terms

Sam's cap

None

Still uncapped

Sam owns

Not fixed

Before the priced round

SAFEs sell

11.46%

Plus Sam at the round price

Founders keep

88.54%

At most

Sam kept the MFN. With no cap, the SAFE converts at the priced-round price, and Sam's part is not fixed until that round.

Look at two orders. If Cedar’s $8M SAFE closes before Sam signs, the MFN cannot reach it, and Sam can get at best the $12M cap. If Cedar’s SAFE closes after Sam signs, Sam can wait and select $8M. For the founders, that costs 1.25% − 0.833% = 0.417% of the company.

Uncapped SAFEs and the YC deal

If no better terms come before the priced round, an uncapped MFN SAFE converts at the round price, as a new investor does. The holder gets no reward for the first risk, except the MFN right.

Some founders want an uncapped SAFE with no MFN. YC gives two methods. The YC FAQ tells founders to use the discount form with the Discount Rate set to 100%. The User Guide tells founders to use the MFN form with the MFN section removed. The two methods give a SAFE that converts at the round price.

The best-known uncapped MFN SAFE is in the YC standard deal. YC invests $125,000 for 7% and $375,000 on an uncapped MFN SAFE. The YC MFN works a little differently from the standard form. It converts automatically on the terms of the lowest-cap SAFE that the company issues between a date near the start of the batch and the priced round. The lesson The YC deal teaches it.

The pro rata side letter

A pro rata right is the right, but not the obligation, to buy more shares in a subsequent round. The YC SAFE does not contain one. From version 1.0, it is in a separate, optional pro rata side letter. YC lets founders give the letter only with capped SAFEs.

The letter gives the right for one round only: the priced round in which the SAFE converts. The investor can buy a part of the new shares equal to its percent of the Company Capitalization. The right stops at the first closing of that round. It also stops just before a sale or a shutdown.

In the conversion example of this module, SAFE 2 owned 10% of the Company Capitalization. The Series A sold 3,400,000 new shares at $1.7647. With a letter, SAFE 2 can buy:

Shares = 10% × 3,400,000      = 340,000
Cost   = 340,000 × $1.7647    = $600,000

Pro rata makes the round larger

Pro rata shares come from the same new shares that the lead investor wants. Suppose that the lead wants a part A of the company, and the SAFEs with letters own a part P of the Company Capitalization. Then the round must sell more, and the founders sell more. Here, A is 20% and P is 10%:

Extra part = A ÷ (1 − P) − A
2.22%      = 20% ÷ (1 − 10%) − 20%

With one 10% SAFE holder with a letter, the new money gets 22.22% in total, not 20%. YC tells founders: “Please consider this pro rata right carefully.” Slow investors with letters can also delay the closing. Two solutions are a minimum check size for a letter, or the YC formula to set a limit on the total.

Work it out

The lead investor wants 20%. Two SAFE holders with pro rata letters own 20% of the Company Capitalization together. How much extra must the round sell for the lead to get its full 20%?

Your answerCheck

A sale before the SAFE converts

A buyer can purchase the company before a priced round. The YC form calls this a Liquidity Event. An IPO or a direct listing also counts. Then a capped SAFE gets the larger of two amounts:

• The Cash-Out Amount: the money that the investor paid
• The Conversion Amount: the value of its shares as common stock at the cap

A sale pays the holders in a fixed sequence. The company pays its debt and its convertible notes first. Then the SAFEs and any preferred stock come next, as equals. Common stock comes last. In a sale, the unissued option pool does not count, because nobody holds those shares.

Take a $1M SAFE with a $10M post-money cap. It owns 10%, so its Conversion Amount is 10% of the money that goes to the owners. Make a guess.

Predict first

A $1M SAFE has a $10M post-money cap, and the company has no debt. Above which sale price does the SAFE get more than its $1M back?

Type a guess before you continue. A guess first, even a wrong one, makes the answer easier to remember.

Your guessSave my guess

Move the sale price in the widget. Then add debt. The debt comes first, so the change point moves up by the size of the debt.

Try it

What a SAFE turns into

Birch signs a post-money SAFE with Northwind Labs. Select what happens next and see what the SAFE gives Birch.

What happens next

RoundSaleShutdownNothing

Birch's SAFE

Post-money valuation cap

$10M

Sale price

$5M

Debt the company repays first

Money back

$1M

The Cash-Out Amount

Value as shares

$500K

10% of $5M

Birch gets

$1M

Founders get

$4M

As shares at the cap, the SAFE is worth only $500K. Thus, the SAFE gets its $1M back, before the founders, and the founders get $4M.

The switch is at a $10M sale, the cap. Below it, Birch gets at most the money back. Above it, Birch gets 10% of what the owners receive.

The SAFE acts like a non-participating preferred share with a 1x preference. The lesson on liquidation preferences explains that term.

The other SAFE forms work in different ways. A discount-only SAFE gets the larger of its money back or its amount ÷ the Discount Rate. Thus, a $100K SAFE with a 20% discount can get $125K. An MFN SAFE that the holder did not change gets only its money back.

Work it out

A $500K SAFE has a $10M post-money cap. A buyer pays $30M for the company, which has $2M of debt. How much does the SAFE get?

Your answerCheck

A shutdown before the SAFE converts

If the company stops operations, the YC form calls it a Dissolution Event. The SAFE does not convert. It gets its money back, but only from the cash that is left after the company pays its creditors. The SAFEs and any preferred stock share that cash in proportion to their claims. The common stock gets nothing until they get all their money.

Here is an example. After the creditors, $300,000 is left. Two SAFEs have claims of $500,000 and $1,000,000, for a total of $1,500,000:

SAFE 1 = $300,000 × ($500,000 ÷ $1,500,000)   = $100,000
SAFE 2 = $300,000 × ($1,000,000 ÷ $1,500,000) = $200,000
Common = $0

Work it out

A company shuts down with $450K after its creditors. Two SAFEs have claims of $250K and $500K. How much does the $500K SAFE get?

Your answerCheck

Quiz · question 1 of 5

Test what you learned

Sam has an MFN SAFE. The company issues a SAFE with a $12M cap and no MFN, and Sam selects those terms. Then the company issues a SAFE with an $8M cap and no MFN. What is Sam’s cap?

• ASam can select the best term from each SAFE
• B$10M, the average of the two caps
• C$8M
• D$12M