Explanation of a SAFE Note
SAFE notes, or a Simple Agreement for Future Equity, are a way for early-stage startups to raise money before preferred (or priced) rounds. In return, the investor gets an agreement for future equity in the startup once certain events occur, such as a large financing round or liquidation event.
Benefits of SAFE Notes
- No immediate sacrifice of equity
- Simple and fast documentation and negotiation process
- Less debate over valuations
- Flexible timelines for future equity conversions
- Used by many types of investors around the world
- Many years of legal precedent
Considerations when using SAFE Notes
SAFE notes can have downsides. Founders could miss hidden risks while closing deals.
Here are things a founder should keep in mind:
- You might miscalculate or lose track of all outstanding SAFE notes and equity that hasn’t yet converted, leading to an unexpected amount of dilution of your equity in the future.
- When you conduct a preferred (or priced) round, SAFE note holders will get a discount based upon the discount in the SAFE note. You might not have anticipated how the discount will impact dilution of equity.
- SAFE terms may not be favorable for your startup. Investors could negotiate specific terms and you need to consider if they are acceptable for you, before agreeing to them.
Investor Benefits of SAFE Notes
SAFE notes also have advantages for investors, such as:
1. Discounted shares
2. More favorable valuations
These benefits come from what are called “discounts” and “valuation caps.”
A discount lowers the price per share for the SAFE note holder when the company sells its stock. These discounts are usually around 10-25%. The exact discount is specified in the SAFE note terms.
A SAFE Note valuation cap is a bit more complex. Investors want lower valuation caps, and founder want higher valuation caps. If the sell price is higher than the valuation cap, the investor gets equity at a more favorable price. If the sell price is lower than their valuation cap, then their investment will generally convert at this lower price.
Elements of a SAFE Note Agreement
A SAFE note includes many elements. Below are some of the key ones to be aware of:
- Investment Amount: the amount of investment the investor is providing to the startup. This is the initial investment amount that will be converted into equity at a later stage.
- Valuation Cap: the maximum valuation at which the investor’s investment will convert into equity. This ensures that the investor receives a fair deal when the future conversion event occurs. A valuation cap is not the same as a company valuation.
- Discount Rate: the percentage discount applied to the price per share when the SAFE note converts into equity during a preferred/priced round. This discount benefits the investor and is specified in the SAFE note. It’s generally between 10-30%.
- Conversion Price Formula: how the conversion price per share will be calculated, often using the valuation cap X the discount rate.
- Maturity Date: the date when the SAFE Note will convert into equity if a conversion event doesn’t occur.
There are many other common terms in a SAFE note, however, these are the main ones we wanted to bring to your attention.
Keep in mind, SAFE notes can vary based upon each country. For example, in the UK, they are referred to as ASAs (Advanced Subscription Agreements) and have other differences.
You should seek the advice of an attorney within the specific country you need to issue a SAFE note.
SAFE Note Example
Imagine you’re the founder of a tech startup called “AI Pet” that’s working on a groundbreaking new product. You need funding to develop your product and grow your business. An investor, “Big Pet Funding Capital Group,” is interested in supporting your startup.
- Investment Amount
Big Pet Funding Capital Group has decided to invest $100,000 into your AI Pet startup to help with product development and other expenses.
- Valuation Cap
You and Big Pet Funding Capital Group agree on a Valuation Cap of $2.2 million because you have a solid team, have a prototype, have some interested customers, and have industry experience. This means if the SAFE note investment converts to equity, it will never convert at a valuation worse than $2.2 million.
- Conversion Event
The SAFE note has two conversion events: A raise from a bona fide investor and you do a preferred (or priced) round and preferred shares are created OR No raise occurs from a bona fide investor within the next 12 months. In this case it will convert based upon the valuation cap.
- Discount Rate
It was also agreed that Big Pet Funding Capital Group would get a discount rate of 20%. This means that when the conversion event occurs, Big Pet Funding Capital Group will get their equity shares at a 20% discount compared to the price per share paid by other investors in that funding round.
- Conversion Price
Example 1: If AI Pet’s valuation at the time of the preferred (or priced) round is $2.5 million, other investors might buy shares at this valuation. But Big Pet Funding Capital Group would get shares at the valuation cap of $2.2 million.
Example 2: If AI Pet’s valuation at the time of the preferred (or priced) round is $1 million, other investors and Big Pet Funding Capital Group would get shares at this $1 million valuation since it’s less than the valuation cap.
- No Interest or Repayment
It’s important to note that this investment doesn’t accrue interest, and there’s no requirement for AI Pet to pay back the $100,000.
For Big Pet Funding Capital Group, this SAFE note process helped reduce the negotiation required on the valuation and reduce the risk of what would happen if the valuation came in lower at the preferred (or priced) round. This is why SAFE Notes can help speed up the negotiation and investment process between investors and founders.
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Using SAFE Notes can be an efficient way for startups to raise funds more quickly and with less friction during the negotiation process, however, you still need to consider the features, benefits, risks, and how to structure them correctly.