A SAFE note, or a simple agreement for future equity, is a legally binding promise between a startup and an investor who has pledged to finance their company in exchange for equity.
As an equity agreement, the SAFE note entitles the investor to purchase a specified number of shares in the future for an agreed-upon price. This allows them to gain an economic advantage if the company raises its share value.
Startups looking to raise seed capital often prefer SAFE notes over convertible notes, as the former do not immediately default into debt.
The defining feature of a SAFE note is its benefit as an investor rights agreement to future discounts. Essentially, this discount defers the actual valuation of shares and allows the investor to purchase a specified amount for a fixed price.
This can save them thousands, if not millions, of dollars and ultimately make their investment far more valuable in the long run.
The discount is the most common SAFE note investor privilege, but it can be substituted with a valuation cap.
Here is an article with more details about how SAFE notes work.
2. Valuation Cap
The valuation cap in a SAFE note sets the limit for the highest amount of money the note will convert stocks into in the future. In other words, the valuation cap determines how much money the future investor can convert their SAFE into equity.
A startup's valuation cap ranges from $2 million to $20 million USD. Using valuation caps allow investors to gain greater shares in the future for a much lower price than a future investor.
The discount and valuation cap is part of the equity agreement between the startup and investor. Both elements determine the SAFE note cost and future value.
Some investors also want an equity commitment letter to ensure they still receive their equity in case of a company merger or acquisition. Because investors take a major risk with seed funding, it is not uncommon for them to go the extra mile and procure as much guarantee for their equity as possible.
Here is an article that explores how investors can use SAFE notes to build their portfolios.
3. Most-Favored Nation Provision
Suppose a startup has investors with multiple SAFE notes. In that case, the most-favored nation provision ensures that the first SAFE will be prioritized above all others. If an investor decides to provide capital and has better terms in their SAFE note, the holder of the first SAFE can request their note to be given those same terms.
The most-favored nation provision is a promise between the startup and investor to not sell any equity to another buyer for a better deal. This gives the initial investor an advantage over all future investors.
Here is an article on most-favored nation clauses.
4. Pro-rata Rights
A pro-rata clause can grant an investor the right to maintain their level of ownership in a company in future funding rounds. This means that as a startup continues to scale, the investor can continue to invest more to maintain their percentage.
Pro-rata clauses help protect an investor’s voting power as a company grows. It allows them to maintain their equity stake in future funding rounds and remain a sizeable voting power even as new shares arise.
However, it is important to note that pro-rata rights are not a legal obligation. Therefore, the investor does not have to invoke them if they do not want to.
These rights are more common in seed funding and early-stage investment, as later investors would not want to use pro-rata rights due to the large sum of money they would have to pay to maintain their percentage.
Here is an article that explores what startups should know about pro-rata rights.
5. Equity Financing
The SAFE note assures the investor that they will be given equity in the business based on their investment amount if a triggering event occurs. This event could be the sale of the company or entering a new funding round.
Because of the possible events that can impact equity, the SAFE note needs to outline what events will trigger the financing.
Both the startup and investor must agree on the amount of equity the investor owns and the events that will trigger the event.
Here is an article about how equity financing works in SAFE notes.
6. Converting Events
Converting events, also known as conversion events, are the events that turn the SAFE note into equity. This can happen during funding rounds or through the sale or merge of the company.
If a private company goes public, the investors can turn their SAFE note into a cash payout or acquire equity in the new entity.
When startups enter their next round of financing, converting events dictate that the investors with SAFE notes will receive shares based on the original terms of their SAFE agreement.
Here is an article that explores how SAFE notes can be used in venture capitalism and how investors make money or acquire equity through converting events.
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