Some start-up companies use SAFE notes as a fundraising device, but what are the advantages and disadvantages, and when should they be used?
In this edition of our Founder Series, we explore SAFE notes as fundraising option for your start-up.
What is a SAFE note?
SAFE stands for Simple Agreement for Future Equity.
Start-up and early-stage businesses often use SAFE notes to raise capital. SAFE notes are a useful device for these businesses to raise money in the early stages when valuation of the business is extremely difficult.
How do SAFE notes work?
In the case of SAFE notes, an investor pays cash up-front. In return, the company gives the investor a contractual right to convert that money into shares on a future event occurring – often at a future-capital raising, or some other trigger or liquidity event that is:
- Agreed by the parties; and
- Stipulated in the terms of the note
What is the difference between SAFE notes and convertible notes?
SAFE notes were created by Y Combinator in the Silicon Valley to offer a simpler alternative to convertible notes and other traditional capital-raising instruments. They are often less complex than convertible notes and subscription agreements, which are ordinarily tailored to the transaction.
For traditional equity-raising tools, convertible notes are the most comparable to SAFE notes. However, convertible notes are inherently more complex because they represent a debt or loan to the business. The debt or loan sits on the balance sheet of the business as a liability and has accompanying interest charges. On the other hand, SAFE notes are considered founder equity.
Another reason SAFE notes are simpler than convertible notes (but potentially riskier for investors) is that SAFE notes do not include maturity dates, which is the date the note would either convert from a debt to equity, or be repaid.
SAFE notes versus Convertible notes
An agreement between a founder and investor, or a start-up and investor
Investor’s funds convert into equity in a future equity round or other liquidity event
Debt (liability on balance sheet)
For more information, see our article about using convertible notes to raise equity.
What is the difference between SAFE notes and a Priced Equity Round?
A Priced Equity Round allows a company to raise funds by issuing shares. It differs from SAFE notes because the shares are issued at a set price. As such, in a Priced Equity Round, founders are unable to postpone a valuation like they can for SAFE notes and convertible notes.
What are the SAFE note caps and discounts?
SAFE notes, like convertible notes, usually include discounts or valuation caps. Investors accept more risk in paying upfront in a SAFE note arrangement, so they will usually be able to negotiate either a discount, a valuation cap, or both. Occasionally, neither a cap nor discount will apply.
As a SAFE note holder, if you negotiate the option of converting your cash into shares at a discounted rate, you will be at a key advantage compared with other investors as part of an ordinary priced round.
For example, say the investor and founder agree on a 20% discount. If a subsequent round takes place with a price per share of $10, the SAFE note investor gets the benefit of converting at $8 per share (based on the 20% discount), this means they will get more shares per dollar invested when compared with the investors in that next round.
Like convertible notes, SAFE note conversion (or valuation) caps cap the price at which money converts into equity. This is attractive to investors because it locks in the maximum price per share they will pay at a later date. It gives them an element of certainty and protection if the company performs strongly and significantly increases its valuation.
Should I use a SAFE note, a convertible note or a Priced Equity Round?
As always, this depends on the particular circumstances of your start-up and your appetite for risk.
SAFE notes are often seen as lower risk for founders, which in turn may mean greater risk for investors who are providing upfront cash, rather than a debt or loan (which can be secured). Despite this, these risks can be outweighed by the benefits of caps and discounts and, often, that the terms of the SAFE noes are more often than not market accepted. This means SAFE notes are likely to be easier to draft and negotiate, making them more cost and time effective.
A Priced Equity Round is complicated by the valuation process, which can be a complex, time-consuming and expensive process for start-ups in their infancy. For founders, issuing shares to third parties right away means their control is diluted very early on. Again, founders’ willingness to accept immediate dilution will vary depending on the runway of the company and how urgently an injection of capital is required.
What are the advantages of SAFE notes?
The advantages of SAFE notes compared with other equity-raising methods are similar to those of convertible notes, for example:
- Simplicity: although it is always critical to carefully draft the terms of SAFE notes to protect your interests, they are often very simple and not subject to the same level of complexity and negotiation as convertible notes or other equity instruments
- Efficiency: unlike buying shares upfront, there is less need for extensive negotiation, due diligence and research. The founder and investor need to form a contract (note) on terms acceptable to both
- Valuation: it is difficult to value your company in its infancy. SAFE notes allow companies to accept investments, while postponing valuation to a later stage
- Control: investors will not be shareholders straight away, so this means founders retain their level of control early on. This also means founders often have more control over the events that lead to conversion
- Lower cost: unlike convertible notes, there is no interest payable by the company on SAFE notes
What are the disadvantages of SAFE notes?
- Flexibility: SAFE notes often give founders less flexibility than convertible notes. This is because the terms of SAFE notes are usually much more standard and objective. On the other hand, convertible notes are bespoke and tailored, involving rounds of negotiations and complex legal drafting
This is not to say that SAFE notes are not flexible. While the terms are somewhat standard, founders should (and can) negotiate terms so that they protect their interests.
The final word
SAFE notes will not suit every company. But for many, they can be a highly effective fundraising option. With careful consideration and planning, we can assist you to navigate these complexities and offer an approach tailored to your business and goals.
There is rarely a one-sized fits all approach so it is critical that you seek our advice if you are considering using a SAFE note.
For more information about the terms and phrases used in the world of equity capital raising, take a look at our Guide to understanding start-up and capital investment terms.
By Milly Berry
Lawyer – Commercial & Property team
DISCLAIMER: We accept no responsibility for any action taken after reading this article. It is intended as a guide only and is not a substitute for the expert legal advice you can receive from marshalls+dent+wilmoth and other relevant experts.