Raising seed capital can be a significant hurdle for the founders of a new technology company. The Simple Agreement for Future Equity, or SAFE note, offers a straightforward path to funding, standing as an alternative to traditional financing methods or a convertible note.
This article explores SAFE notes, how they function, their key differences from convertible notes, and why they might be a great option for your tech startup.
What Is a SAFE Note?
The SAFE note was first introduced by Y Combinator in 2013 to simplify the funding process for early-stage startups.
Unlike traditional funding methods, SAFE notes eliminate the need to value the business. This is particularly beneficial for entrepreneurs who may not be able to justify a short-term valuation to investors when the company has not yet found product-market fit.
SAFE notes also remove other complexities, such as interest rates, maturity dates, and loan obligations that come with convertible debt. Investors provide capital or services upfront in exchange for future equity in a startup, typically at a discount. The transfer of equity takes place only if a conversion event occurs in the future, such as a financing round of at least $1m, helping to avoid early equity dilution.
How Do SAFE Notes Work?
SAFE notes are designed to streamline the way early-stage startups engage with investors.
Here's a breakdown of how they work:
Initial Investment
Investors provide startups with capital or services upfront, but instead of receiving immediate shares in the company, they receive a promise of future equity. This is where the "simple" in SAFE note comes into play, as it cuts through the complexities of traditional investment terms.
Trigger Event
The note converts into equity only if a defined trigger event, also known as a conversion event, occurs. This event could be the startup's next priced equity round, an IPO (Initial Public Offering), a liquidation event, or another significant event. The conversion is based on a simple set of predefined conditions that aim to benefit the investor, acknowledging the early investor’s support with favourable terms.
Valuation Cap & Discount Rate
These are the two critical elements that dictate the conversion terms.
Valuation Cap
The valuation cap sets a maximum valuation at which a SAFE converts into equity, ensuring they receive a fair share of the company relative to their early investment, even if its valuation skyrockets.
Usually it will be set at the expected valuation at the time of the next trigger event. For example, if you believe you are likely to raise capital for your Series A round at a $20m valuation in 12 months, $20m might become your valuation cap.
Discount Rate
The discount rate is another mechanism that aims to provide investors with equity at a lower price than that offered to investors in the next round of financing. Again, this serves as a reward for the SAFE note holder’s early investment risk.
The most common discount rate used by startup companies in Australia and New Zealand is 20%. However this varies depending on factors such as founder experience, the industry, and whether the trigger event is expected to happen very soon or if it’s unlikely to happen for a long time.
Transfer of Equity
When a trigger event occurs, the notes convert into preferred stock or common stock depending on what was agreed. The conversion price favours the investor by converting at the more advantageous option between the valuation cap and the discount rate outlined in the SAFE agreement.
Benefits of SAFE Notes
There are several founder-friendly reasons SAFE notes make sense for early-stage startups, particularly those who have yet to establish a pre-money valuation, and their investors.
Benefits for Startups
Flexibility
Capital raising through SAFE notes offers the flexibility to secure capital without setting a pre-money valuation, streamlining the fundraising process.
Speed
SAFE notes enable faster closing of funding rounds. This speed allows startups to secure capital when needed quickly and helps new investors join your cap table efficiently.
Simplicity
With fewer complexities than convertible notes, SAFE notes reduce paperwork and legal fees.
Growth Focus
With no interest or maturity dates, startups can concentrate on scaling their business without the burden of debt repayment.
Solvency
Depending on the terms, SAFE notes are typically treated as equity on the balance sheet, rather than debt, thus removing their impact on the balance sheet solvency test.
Benefits for Investors
Early Access to Investment Opportunities
SAFE notes offer investors a chance to back startups early, by simplifying the process of making an investment.
Potential for High Returns
Given the discounted equity and potential for significant valuation increases, investors can achieve high returns on their initial investment if the startup performs well.
Alignment with Startup
The conversion of SAFE notes into equity links investors' success with the startup's growth. Pro rata rights also allow investors to keep investing in later rounds, fostering a partnership-focused approach.
Discounted Equity
Investors might benefit from a discount rate on future equity, enhancing potential returns as the company's valuation increases.
Disadvantages of SAFE Notes
SAFE notes present unique benefits to both founders and investors. However, they also carry specific limitations that founders and SAFE investors should seek professional legal and financial advice to understand fully.
Disadvantages for Startups
Equity Control
Using SAFE notes might result in unexpected equity dilution, reducing founders' ownership stake in their business.
Investor Misalignment
Differences in company valuation and equity conversion expectations can emerge, leading to potential conflicts between founders and investors.
Future Fundraising Complexity
Managing several different SAFE notes with varied terms can complicate later funding rounds.
Disadvantages for Investors
Ownership Dilution
Conversion of SAFE notes into equity can dilute an investor's stake, especially with subsequent fundraising rounds.
Valuation Cap Challenges
Valuation caps might not accurately reflect the startup's potential value, especially if its valuation significantly increases.
Indefinite Returns
With maturity dates, the timeline for realising returns on SAFE notes is predictable, which can complicate investment strategies.
Equity Dilution
Converting SAFE notes into company equity can dilute the existing capitalisation table, potentially deterring some investors.
SAFE vs. Convertible Notes
SAFE and convertible notes are both popular methods used by early-stage startups looking to raise pre seed or seed capital from investors. While similar, there are some critical differences in their structure and terms.
SAFE Notes
- Equity-like instruments; no valuation is required.
- Simple and flexible; ideal for fast cost-effective fundraising.
- Convert into equity during future financing.
- No interest or maturity dates, minimising direct financial pressure.
Convertible Notes
- Convertible notes work as debt instruments that convert to equity later.
- Convertible securities are generally more complex, with potentially higher legal costs.
- Have interest rates and maturity dates, increasing structure.
- Offer more protections to investors, like liquidation preferences.
How to Issue a SAFE Note: Step-by-Step Guide
1. Consult Legal Advisors
Imagine your Fintech startup (structured as an LLC) is looking to raise $100,000 Pre seed funding. Although not always necessary, you should ideally consult a law firm that specialises in startup finances and understands the nuances of your industry. They'll help you kick off the SAFE note issuance process by drafting a document tailored to your situation.
2. Define Key Terms
You and your legal team determine critical terms for the SAFE note. In our example, let’s imagine you opt for a $3 million valuation cap, and a 25% discount rate. It is obviously important to ensure these terms are attractive to investors while protecting your startup's future growth potential.
3. Draft the SAFE Note Agreement
Draft the SAFE note with legal guidance to include your chosen terms alongside the specified conversion or trigger event, such as an equity financing round of at least $1 million. You might also consider including milestones that, when achieved, adjust the valuation cap or discount rate.
For a practical starting point, we suggest utilising the SAFE Note template provided by Kindrik Partners.
4. Present the SAFE Note to your Investor
Offer this SAFE note to your potential investors such as angel investors, venture capital firms, or a venture studio. Naturally this needs to accompany a detailed overview of your business and growth strategy, usually in the form of a pitch deck—VCs and other investors must understand the investment vehicle and the vision they're investing in.
5. Execute the Agreement
Assuming your investor is happy with the terms you have presented, you would solidify this through a formal SAFE Note agreement and distribute the signed document to all parties to keep for their records.
6. Equity Conversion
Now let’s imagine 12 months later your startup raises a $1m Seed round of funding at a pre-money valuation of $5m from new investors. This causes an equity conversion to be triggered, as the capital raise meets the $1m trigger event.
To determine the valuation at which the SAFE note will convert at we take the lower of:
- The discounted valuation; the seed round valuation of $5m less the 25% discount, which is $3.75m.
- The valuation cap; which was $3m.
In this case the valuation cap of $3m is less than the 25% discount on the pre seed valuation of $5m, so this valuation will be used to determine the conversion value. This means the $100,000 SAFE note will be converted to the relevant number of shares at a $3m pre-money valuation.
The SAFE note would convert first, so the $3m pre-money valuation would become a $3.1m post-money valuation. The SAFE note investor would therefore get 3.23% of the company, this is calculated as $100k/$3.1m.
After the SAFE note has converted, the new seed investment capital would come in causing the SAFE note investor to take part in the equity dilution. The new investors would be investing in a $5m pre-money valuation which would become a $6m post-money valuation. For their $1m investment they would get 16.7% of the company, this calculated as $1m/$6m.
The Future of SAFE Notes in Startup Financing
Adoption
While SAFE notes are very common in Silicon Valley and more mature startup ecosystems they are not yet as common in New Zealand and Australia. We anticipate that SAFE notes will continue to gain traction in Australasia as our startup ecosystem matures. Their appeal lies in their simplicity and the benefits they afford both parties which is crucial for the tech sector which needs to prioritise speed and innovation.
Evolution
SAFE notes will likely continue to evolve. We expect to see new types of SAFE notes that address the changing needs of startups and investors alike, potentially incorporating more standardised terms and offering nuanced investor protections.
Alternatives
SAFE notes will likely inspire the creation of new financial instruments. These alternatives could refine or redefine the terms of engagement between startups and investors, providing more tailored solutions to industry-specific challenges. It will be interesting to see Blockchain technology's impact on startup fundraising.
Continued Relevance
At their core, SAFE notes embody the principles of flexibility, efficiency, and alignment of interests. These qualities are highly valued in the startup ecosystem and are likely to ensure their continued popularity and relevance.
Key Article Takeaways
SAFE notes have become an important funding tool, especially for early-stage companies. They protect startup founders from premature equity dilution and avoid having to value a business on day 0. They also provide an efficient mechanism for investors to invest in high return opportunities without upfront negotiation on valuation.
Read some key takeaways from this article:
- SAFE notes are legal instruments used in seed-stage financings that give investors the right to convert their investments into equity at a later date.
- SAFE notes offer advantages for startups, such as flexibility, streamlined processes, and no interest or maturity date. They also offer discounted equity and potential preference during asset distribution for investors.
- While SAFE notes have risks and limitations, conducting thorough due diligence and seeking professional advice can help mitigate potential drawbacks.
- SAFE notes differ from traditional convertible notes regarding interest payments, repayment, company valuation, and debt versus equity representation.
- The future of SAFE notes in startup financing looks promising due to their simplicity, flexibility, and investor-friendly features.
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