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How the pre-money SAFE (Simple Agreement for Equity) Works - YouTube
Channel: StartupSOS
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how does the simple agreement for future
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equity work that's what we'll talk about
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in today's video hi I'm Steve Morris and
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I use this startup SOS channel to
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provide practical how-to advice for
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first-time entrepreneurs so today's
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topic the safe now the safe was created
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in 2013 by Y Combinator to provide a
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simpler more entrepreneur friendly way
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of raising money in an early-stage
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startup they did update it in 2018
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because of some problems that did crop
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up and we'll talk about that update in
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the next video but for this video our
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focus is on the original version of the
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safe and how exactly it works so the
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safe is an example of a convertible
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security in other words it's a way for
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an investor to provide a start-up with
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funding today in a very simple you know
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easy to do legal agreement that in the
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future converts to ownership in the
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company and that sense it's much like a
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convertible note they're both examples
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of convertible securities we talked
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about the convertible note in the
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previous video you might check that out
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if you're not familiar with notes and a
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link to that is up at the top how
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exactly does a safe compared to a
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convertible note well there are some
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important differences first of all a
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safe has no interest rate and it has no
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maturity date note of course always has
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both of those also the safe like the
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note does convert into ownership in the
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future when there's an equity investment
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round but unlike the convertible note
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there is no size requirement for the
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safe the safe converts at any equity
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investment typically a convertible note
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in part of its terms will specify some
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minimum size for a future equity round
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that will cause the note to to convert
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into ownership and finally there's an
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equity investment round in the future
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we'll call it a Series A that causes the
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safe money to convert into ownership now
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the safe investor might receive the same
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stock the same preferred shares that
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that series a investor does but very
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often the safe investor receives a
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slightly different version
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preferred shares called these safe
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preferred we'll explain that in a minute
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a safe has no maturity date unlike a
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convertible note so how long does it
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last well a safe will terminate if an
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equity investment occurs that causes the
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safe to to convert into equity than the
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safe itself of course goes away or if
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there's an acquisition the safe will
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terminate if there's an initial public
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offering that terminates it and finally
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of course if the company goes out of
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business and shuts down that terminates
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the safe but if none of those four
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events happens as safe theoretically can
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go on forever there are actually four
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different versions of the safe the first
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one is called the standard safe and it
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has a valuation cap but no discount the
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second has a valuation cap and a
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discount the third version has a
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discount but no valuation cap and the
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fourth version has no cap and no
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discount but it has an MF n a most
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favored nation clause we'll get into
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that more in a minute but in terms of
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caps and discounts and we did talk about
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those in the context of the convertible
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note you might check out that video for
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that overview of caps and discounts so
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what exactly does the safe money pay for
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stock when it converts into ownership
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well it depends on the scenario let's
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consider this scenario where there's a
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cap that no discount if the cap is less
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than the pre-money value of that future
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round then the cap is going to kick in
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and determine the price that's paid by
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the safe investor the price is pretty
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easy to calculate it's the total number
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of shares that's the total fully diluted
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shares the number shares being issued to
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the new investors plus all of the
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options that are allocated and the
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options they're actually awarded divided
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by the pre-money cap and that of course
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will by definition be a lower price than
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is paid by the future equity investors
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if the pre-money value in that future
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round
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is equal to
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lower than the cap amount then the safe
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investors receive the same stock at the
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same price as those equity investors now
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consider the scenario of a discount but
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no cap well in that case the safe
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investor receives as the stock at that
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discounted price and in that case since
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it's a lower price than is being paid by
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the equity investors they'll receive the
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safe preferred shares one more scenario
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what is the safe investor pay if the
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safe money has both a discount and a cap
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well you calculate the stock price with
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a discount you calculate it again with
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the valuation cap and the safe investor
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gets the lower of those two prices what
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exactly is this safe preferred stock as
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opposed to the standard preferred shares
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that the equity investors receive well
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the safe preferred is issued when the
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safe investor is paying less than the
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equity investors if they're paying the
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same because say there was no discount
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and the cap didn't kick in then they
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simply receive the same preferred shares
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that the equity investors receive but in
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the case where the safe investor is
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paying less for the stock they have this
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slightly modified version of shares
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called the safe preferred it's identical
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to the shares the equity investors
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receive with just three differences the
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conversion price of course is different
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so that's laid out in the terms again
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it's the price determined by other the
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discount or by the valuation cap they
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get a different dividend rate and a
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different liquidation preference both
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based on what they actually paid for
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their shares as opposed to what the
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equity investors paid now why is that
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important well let's use liquidation
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preference as an example liquidation
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preference is a term that comes into
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play when a company gets acquired so
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let's say there's a series a investment
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and the stock price that the equity
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investors receive is $1 but let's assume
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that these safe investors get that stock
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for a lower price because in this case
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let's say it was the cap the valuation
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cap was
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lower and so they got the stock at half
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the price say fifty cents instead of a
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dollar that's very common to have in a
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series a set of terms what's called a
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liquidation preference so in the case
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where the company gets bought what the
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liquidation preference says is that very
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typically the investors will get paid
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first so you've got the proceeds from
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the acquisition first the investors
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might get paid one X of what they
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actually invested and then their stock
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would convert their preferred shares
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would convert into common stock and from
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then on they would participate in the
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proceeds with the other common
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shareholders so again of course pro rata
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given what the proceeds are everybody
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receives their fraction of the proceeds
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now that would be called a 1x
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participating liquidation preference
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again it's not not the only way to do a
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liquidation preference but that's a very
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common one here's the problem if I'm a
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safe investor I paid half for my shares
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of what the equity investors did and
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unless that's dealt with in the term
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specifically what'll happen is I'll get
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paid as my liquidation preference
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actually twice the money that I put into
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the deal not one X but two X because the
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One X is based on the equity price for
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the stock that the equity investors paid
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I paid half that so that's the problem
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without dealing with that specifically
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in the terms the safe investor really
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gets more money than they should in the
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1x participating deal so that gets
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corrected in the the safe preferred
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shares and that's I think the most
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important difference pretty much all the
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other terms are the same as with the
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standard series a preferred stock now we
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mentioned that most favored nation or
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MFN clause which one of the four
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examples of the safe includes that works
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much like it does with a convertible
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note which is to say if in the future
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you give a future safe investor better
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terms than a current investor that
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current investor has the option of
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adopting those
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more favorable terms so in the case of
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the safe the version that has the MFM
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has no discount and no cap but if in the
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future you give somebody a safe with a
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discount and/or a cap then that earlier
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safe investor has the right to adopt
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those terms including the discount and
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or the cap some of the other common
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terms that you'll see in a safe number
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one pro rata right meaning that the the
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safe investor has the right to purchase
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additional shares what if there's a
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liquidity event say an acquisition
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before the safe money has converted into
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stock well in that case a safe investor
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gets their choice they can either get
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their money back or if it's a better
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deal they can take their safe money and
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convert it into stock at a valuation
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determined by the valuation cap and
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receive their funding that way in in a
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dissolution the safe investor has the
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right to get their money back now of
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course that assumes that there's any
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money to give back very commonly in a
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dissolution of a company there's no
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money left and everybody ends up being
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out of luck and then finally there are
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some miscellaneous representations for
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example the investors probably represent
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that they are accredited investors and
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there are some other representations for
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both investors and for the company so
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what are the advantages of a safe well
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like any convertible security one thing
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a safe does is it delays devaluation in
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the company until you make more headway
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and you're worth more so in the future
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when you have that priced equity round
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you'll sell less stock in the company in
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order to convert those safe dollars into
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stock so you you minimize your dilution
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it's also a very simple instrument
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there's very few terms to negotiate so
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it's a fairly fast thing to put in place
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and low-cost from a legal point of view
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it just doesn't take a lot of legal help
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to do a safe unlike the convertible note
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there's no interest rate and no maturity
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dates so those are certainly both pluses
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for the entrepreneur how about drawbacks
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or really about the only drawback is
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that it is easy to lose track of the
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dilution that you're incurring as you
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close safe money the safe really since
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it
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not purchasing stock at the time you
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collect the money you can lose track of
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how much it's going to affect your
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dilution when it does convert into stock
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in the future in that future round now
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that's one of the reasons why Combinator
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updated the safe in 2018 and made some
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pretty significant changes to it again
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we'll talk about that in the next video
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so that's a summary of how the simple
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agreement for future equity works the
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original 2013 version if that was
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helpful please click the like button and
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share it with other entrepreneurs who
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might benefit and if you haven't
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subscribed yet please do that use the
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button down in the corner once you
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subscribe you can also click on the bell
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icon which then will notify you when we
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have future videos and again we have at
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least one more coming up in this series
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and that'll be on the series seed a
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standardized set of terms for a priced
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equity investment round and of course if
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you have any questions please leave a
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comment and I'll certainly do my best to
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answer those questions that's it until
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next time thank you very much for
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watching
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