SAFE Note: A Guide for Startups and Investors

What Is a SAFE Note?

SAFE (or simple agreement for future equity ) notes are financial agreements that startups often use to help raise seed capital. Essentially, a SAFE note acts as a legally binding promise to allow an investor to purchase a specified number of shares for an agreed-upon price at some point in the future.

The Securities Exchange Commission (SEC) defines a SAFE as "an agreement between you, the investor, and the company in which the company generally promises to give you a future equity stake in the company if certain trigger events occur." [1]

How SAFE Notes Work

When a company is first starting out, there is typically very little data, making it difficult to assign the company a valuation. SAFE notes work by allowing you to postpone the company's valuation until a later date by promising investors a set of terms for when their investment will convert into equity. The terms often used are valuation caps and discounts, both of which reward the early investors for the risk they have taken.

How Valuation Caps Work

A valuation cap essentially sets a maximum (or ‘cap’) on the valuation the investors money can convert into equity. This means if the startup raises future financing at a valuation above the valuation cap promised to the SAFE note holders, their money will convert into equity at the price of the valuation cap (not the higher valuation), giving them a discount on the shares they will receive.

Here is an example of what you may see in a SAFE note "The “ Pre-Money Valuation Cap ” is $9,000,000." [2]

How Discounts Work

A discount will allow SAFE Note holder’s money to convert into equity at a discounted rate compared to the next round of investors. For example, if the startup raises a future financing round at a valuation lower than the valuation cap, the SAFE Note holders’ investment will convert into equity at a discounted rate.

Here is an example of what you may see in a SAFE note "The “ Discount Rate ” is 20%." [3]

No Interest, Maturity Date, or Repayment Terms

Unlike convertible notes, SAFE notes are not debt and do not have an interest rate, maturity date, or any sort of repayment terms. This is one of the main reasons they are attractive to startups, since they are a way to get investment in within taking on any burden of debt. The incentive for the investors is the benefits they will receive through the valuation cap or discount, depending on what the startup offers.

Pre-Money vs. Post-Money SAFE notes

It is worth noting there are commonly used types of SAFE notes. These are pre-money SAFEs and post-money SAFEs. The main difference is a pre-money SAFE note's valuation cap is calculated from the pre-money valuation of the startup, meaning the valuation of the startup before money is invested in the next financing round. A post-money SAFE's valuation cap is calculated against the post-money valuation of the startup, which includes the money being invested in the next equity round.

For example, if a startup issued pre-money SAFE notes with a $4 million valuation cap, and the startup raises $2 million in their next financing round at a post-money valuation of $12 million, the valuation cap would be compared to $10 million pre-money valuation (does not include the money being invested) as opposed to the $12 million post-money valuation (which includes the new capital being invested).

Example Steps for Using a SAFE Note

Here's a look at the basic steps that take place when utilizing a SAFE note for your startup:

1. An investor provides seed money in exchange for promised future equity.
2. The company uses the original investment to build the business.
3. Once progress has been made, you find another investor, giving your company what is known as post-money valuation.
4. You can then calculate the company's new price per share with this information.
5. After you know the price per share, you can convert the SAFE note into the applicable number of shares in the company and distribute them to the SAFE investor. SAFE notes typically convert after an equity financing round, like a Series A round.

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Pre-Money SAFE Note (Valuation Cap Only)

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Key Elements in a SAFE Note

SAFE notes contain a few primary terms that alter how they eventually convert to company shares, and they are:

• Discounts: SAFEs sometimes apply discounts, usually between 10% and 30%, on future converted equity. This means that the investor will be purchase shares at a discount on the future financing. For example, if the company offered SAFE note holders a 20% discount and achieves a valuation of $10 million, with shares available to new investors at $10, the SAFE investors will be able to buy their shares at $8, thus receiving a 20% discount.
• Valuation Caps: Another way for the investor to get a better price per share than future investors is through a valuation cap. Valuation caps are a term in SAFE notes that establish the highest price, or cap, that can be used when setting the conversion price.
• Most-Favored Nation Provisions: In cases where there are multiple SAFEs, this term requires that the company notify the first SAFE about it, including the terms for the subsequent note. If the first SAFE holder finds the second SAFE's terms to be more favorable, they can ask for the same terms.
• Pro-Rata Rights: Pro-rata, or participation rights, allow investors to invest extra funds so that they can keep their percentage of ownership during future equity financing.

SAFE Notes vs. Convertible Notes

SAFE notes are a type of convertible security, while convertible notes are a form of debt that can convert into equity once certain milestones are met. Because of this, convertible notes usually have a maturity date and an interest rate. Though convertible notes are a bit more complex, both SAFE and convertible notes are:

• Helpful tools for startups trying to grow or scale their business.
• Converted to equity eventually.

Overall, the biggest difference to know between SAFE notes and convertible notes is that SAFE notes do not have a maturity date, interest rate, or any repayment obligations.

SAFE Note Conversion Examples

After early investments, SAFE notes will typically convert into equity if the startup hits their milestones and reaches a ‘trigger event.’ A trigger event is an event that causes the SAFE notes to convert into equity according to their predefined terms offered to investors.

The SEC defines "Conversion Terms" as "These are the specific terms by which the amount you invested in the SAFE gets converted into equity." [4]

Below are two common examples of SAFE note trigger events:

Equity Financing Round

If a startup can raise an equity financing round by selling preferred stock to new investors, this will ‘trigger’ the SAFE notes to convert into preferred stock. Shares will be priced according to the terms of the SAFE notes, which typically uses the valuation cap or discount. For example, if the equity financing round (e.g., series A round) values the company above the valuation cap agreed to with the SAFE note holders, their investment will convert into shares at the price of the valuation cap which gives them a lower price per share than the new investors.

Sale of the Company

If a startup is acquired before an equity financing round, this will trigger the SAFE notes to convert into equity. Typically, the SAFE notes will convert into equity right before the sale is made so that the investors can participate in the proceeds of the sale. The SAFE notes will convert based on the terms of their agreement.

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Advantages of Using SAFE Notes

There are several benefits of using SAFEs, including that they:

Are Less Complex Than Other Options

One of the primary benefits of SAFE notes is that they are typically less than five pages long and are simple enough for anyone to understand. This is largely due to the fact that there aren't any end dates or interest payments to worry about, unlike with a convertible note.

Contain Important Stipulations

SAFEs protect both startup companies and investors by including key agreements for potential future occurrences, such as:

• Changes of control
• Early exits by investors and company owners
• Company dissolution
• Bankruptcy

Have Simple Accounting Requirements

SAFE notes are included in a company's capitalization table, eliminating the need for any complicated tax consequences.

Provide Fewer Points for Negotiation

Since SAFEs are so simple, there are fewer terms to negotiate, making everything that needs to be discussed clear and concise. In fact, the only things that really need to be negotiated are the discount rate and the valuation cap.

Give Company Owners More Control

Without repayment obligations and maturity dates looming over your head, you end up having a lot more freedom and flexibility as a company owner.

Offer Better Benefits for Investors

Since SAFE notes are converted into preferred stock, often at a discounted price, investors have a lot of incentive for using them. Investors could end up with benefits that are actually better when compared to their original investment.

The Challenges of Using SAFE Notes

SAFE notes offer a number of benefits, but they do come with their fair share of challenges, such as that they:

Can Be Risky

Because a SAFE note's outcome depends on how the company progresses, investors don't have a guarantee that it will ever convert into equity.

Don't Offer Continual Revenue

Convertible notes provide investors with continual interest payments. SAFE notes aren't a loan, meaning investors don't receive any sort of interest or payments. As a result, investors sometimes end up making less over time.

Don't Provide Dividends

A lot of companies provide dividends, either in the form of payments or additional shares, to investors when the company performs well. In most cases, SAFEs don't supply investors with dividends. Instead, an investor's reward for investing in a SAFE is equity. It is worth noting that the type of companies that are financed using SAFE Notes would not plan to pay dividends to investors. Any profits generated are typically put back into the business for growth.

Have an Unknown Future Impact

SAFEs weren't developed until 2013 [5], when the team at Y Combinator, a Silicon Valley accelerator, decided that there needed to be a financial tool that made seed investment a little less complicated. In the short-term, this new financial instrument is efficient and effective, but we're still unaware of the potential long-term consequences for company owners and/or investors. Additionally, the newness of SAFE notes means that investors and lawyers are often less familiar with them, and, therefore, wearier of using them.

Require the Business To Be Incorporated

In order to use SAFE notes during negotiations, a company has to be incorporated. This is because this type of investment is included in a C corporation 's capitalization table, just like other stock options. That means that if you're hoping to issue SAFE notes and your business is structured as a limited liability company, or LLC, you will have to:

• Restructure.
• Become incorporated.
• Obtain the necessary legal services.
• Pay applicable fees.

May Necessitate a Fair Valuation

Another possible expense associated with issuing SAFE notes is the potential need for a fair valuation, also known as a 409a, to appraise your startup stock's fair market value.

Lack Minimum Requirements

SAFEs don't have a minimum requirement for equity to enter conversion, which can have a negative impact on future investments. Minimum requirements allow you to readjust the note's terms, giving smaller investors the opportunity to compete.

Could Dilute the Company's Valuation

Company owners could unknowingly end up owning fewer shares in their company down the road because they forget to account for any potential dilution. As a result, investors will be less inclined to invest in the company.

As a startup, finding funding is often one of the very first challenges that you'll face. By knowing your options and learning about their advantages and disadvantages, you can make the right decision for you and your company. SAFE notes, while still fairly new, provide an excellent opportunity for you to develop your business without the threat of impending interest payments looming overhead.

What Happens to SAFE Notes if a Startup is Acquired?

The acquisition of a startup is considered a ‘trigger event,’ which means the SAFE notes will convert into equity based on the terms of their agreement. The conversion typically takes place right before the sale happens, so that the SAFE note holders can participate in the proceeds of the sale.

Depending on the terms of the acquisition and SAFE note, investors may receive cash proceeds, equity in the acquiring company, or both. It is worth noting that SAFE notes convert into preferred stock, so depending on the liquidation preferences, SAFE note holders may be entitled to receive the proceeds of the sale before common stock holders of the company.

Common Types of SAFE Notes

When issuing a SAFE note, you the most common scenarios are:

• A valuation cap, but no discount
• A discount, but no valuation cap
• A valuation cap and a discount
• No valuation cap and no discount

Sources

1. ^ https://www.sec.gov/oiea/investor-alerts-and-bulletins/ib_safes
2. ^ https://www.sec.gov/Archives/edgar/data/1657493/000121390021030690/ea142082ex5-2_rentberry.htm
3. ^ https://www.sec.gov/Archives/edgar/data/1657493/000121390021030690/ea142082ex5-2_rentberry.htm
4. ^ https://www.sec.gov/oiea/investor-alerts-and-bulletins/ib_safes
5. ^ https://www.ycombinator.com/blog/announcing-the-safe-a-replacement-for-convertible-notes/