SAFE Note (Financing)
What is a SAFE Note?
SAFE stands for “Simple Agreement for Future Equity.” SAFEs are a form of convertible financing used by startups to raise money from investors. In exchange for future equity in the startup, investors agree to provide financing today. SAFEs are similar to convertible notes, but they are not debt instruments, they’re simpler and are typically executed more quickly.
The concept of SAFEs came from Y Combinator, who recognized the need from founders of pre-revenue companies to raise their first round of funding. In just under a decade, SAFEs have become one of the most widely adopted forms of financing.
How do SAFE notes work and what are the typical terms?
SAFEs give investors the right to convert their investment into equity during a future equity round or liquidation event. The amount of equity that the SAFE converts into is based on either a valuation cap or a discount rate.
- Valuation cap. The valuation cap of SAFE outlines the maximum price at which it will convert. The lower the valuation cap, the less advantageous the deal is for founders because investors can convert their notes into more equity in the company.
- Discount rate. The discount rate of a SAFE outlines the ‘discount’ that investors will receive on the priced round when it converts. The higher the discount, the less advantageous the deal is for founders because investors receive more equity.
- Minimum investment. This is the minimum dollar amount that an investor must invest to participate in the SAFE.
What are the various types of SAFE Notes?
There are four types of SAFEs which include:
- Valuation cap, no discount
- Valuation cap and a Discount
- Discount, no valuation cap
- No valuation cap and no discount
What is the Most Favored Nation clause in SAFE Notes?
When a SAFE does not have a valuation cap or a discount rate, it is said to have a “Most Favored Nation” clause. This means the investors (e.g. SAFE holders) receive the same conversion terms as those offered to investors in the next priced equity round.
What is the most advantageous SAFE note structure for founders?
The most advantageous SAFE structure for founders is one that has a high valuation cap and a low discount rate. This ensures that investors cannot convert their shares at a low valuation and do not receive a large discount on the price of the shares.
What is the difference between a pre-money and post-money SAFE note?
Pre-money SAFEs calculate capitalization before the capital from the SAFE comes in, which makes it very challenging, if not impossible, to determine how much ownership the founders, founding team, and investors have.
Post-money SAFEs calculate capitalization after the capital from the SAFE comes in, which makes it fairly straightforward to determine how much ownership the founders, founding team, and investors have.
Why do startups and investors use SAFE notes?
Startups and investors use SAFEs because they are lightweight, standardized, and straightforward—resulting in quicker execution times. Typically startups can close a round of funding in less than a month with SAFEs, as opposed to months with traditional term sheets.
SAFEs protect and align the interests of both the startup and the investors, as they only convert once certain milestones, such as valuation, or strike price is hit.
What are the advantages of raising capital via SAFE Note financing?
There are several advantages of raising capital via SAFEs. SAFEs are:
- Quick: SAFEs can be issued quickly, which makes them a good option for companies that need funding to fuel their growth, or fund their operations.
- Flexible: The terms of a SAFE can be customized to fit the needs of both the company and the investors. Also, the lack of pre-defined terms and a maturity date gives the startup total freedom.
- Not Debt: SAFEs are not debt, which means that the startup does not have to make payments and cannot default, because it’s not a loan.
What are the disadvantages of raising capital via SAFE Note financing?
Despite the advantages of SAFE Note financing, there are also some disadvantages to consider, which include:
- Loss of Control: As SAFEs convert into equity, founders and early employees will be required to give up some level of control in the company.
- High Cost: SAFEs convert into equity, which can be one of the costliest forms of capital depending on how well the company performs. The difference between a few points of equity can represent hundreds of millions of lost value for founders.
What’s the difference between SAFEs and Convertible Notes?
SAFEs and Convertible notes are both convertible financing options. However, unlike convertible notes, SAFEs do not:
- Mature. SAFEs do not mature, as such, founders do not need to prematurely raise a priced equity round.
- Accrue Interest. SAFEs do not accrue interest during the period leading up to or following their conversion into equity.
Can you provide an example of a SAFE note in action?
Suppose Company X is a startup that is developing a new app. The company has been working on the app for six months and is preparing for launch. The company needs $1,500,000 to hire additional engineers, and sales staff, and extend its runway by nine months until it can raise its seed round.
Company X decides to raise money by issuing a SAFE. The company asks a group of investors called angels, for a $1.5M check, in exchange for 10% equity in the company when it reaches a valuation of $25 million.
Company X finishes developing the app and launches it. The app is a success, and Company X quickly grows in value. After six months, the company raises a seed round of funding at a $25M valuation. At this point, the initial group of investors converts their SAFE in exchange for the 10% equity initially agreed upon.
Can the terms of SAFE Notes be negotiated?
Yes, the terms of a SAFE can and should be negotiated. Strongly consider avoiding SAFEs with a low valuation cap and a high discount rate. SAFEs structured like this come with a significantly higher cost of capital compared to those with either a high valuation cap or a low discount rate.
Who are the top providers of SAFEs Notes?
Some of the top providers of SAFEs include Y Combinator, 500 Startups, and Andreesen Horowitz.
When should startups use SAFE Note financing?
The ideal time to use a SAFE is before a seed round of funding. This is because startups can leverage SAFEs to quickly raise money without giving up too much equity. SAFEs are less common for late-stage startups because they have likely already had several priced rounds and SAFEs typically involve lower valuations.
What are the qualified conversion events for SAFEs outside a valuation cap?
There are only a few scenarios in which investors can convert their SAFE without reaching an agreed-upon valuation cap, these include:
- Dissolution: Dissolution events occur when there is a voluntary or involuntary termination of the company.
- Liquidity: Liquidity events may occur via an acquisition by another entity or via an initial public offering.
- Insolvency: Insolvency occurs when the business can no longer meet its financial obligations to lenders as debts become due, and thus become bankrupt.
When a dissolution or insolvency event occurs, the holders of the SAFE attempt to recoup their investment through the sale of the assets of the business. In a liquidity event, investors receive cash or stock equivalent to the shares they’ve purchased.
What are the financing alternatives to SAFE Note financing?
Some of the financing alternatives to SAFE Note financing include convertible notes, equity financing, and revenue-based financing.
- Convertible notes: Convertible notes are a form of debt that can be converted into equity at a later date. They are typically utilized by startups that don’t have a valuation.
- Equity financing: Equity financing is a type of financing where the company sells equity, or ownership, in the company to investors in exchange for funding. Venture capitalists, angel investors, angel syndicates, private equity groups, and more all invest in companies via equity financing. You can learn more here.
- Revenue-based financing: There are two types of revenue-based financing: receivables factoring and receivables financing. The main difference is the sale of individual invoices (factoring) vs a cash advance on future projected revenue streams (financing). You can learn more here.