SAFE note: what it is and how to use it

Startups are essential vehicles of innovation in various industries. Biotechnology, software, logistics, real estate, and many other industries are impacted by startups.

Oftentimes, it costs a lot to get startups off the ground in the initial stages, and that’s where investors come in.

Multiple investment tools can be used to handle the terms of the investment and one of them is the SAFE note.

In this guide, you’ll learn what a SAFE note is, the components of a SAFE note, how to use it, and much more.

Definition and Purpose of SAFE Note

A SAFE (Simple Agreement for Future Equity) note is a financial instrument used in early-stage startup financing. It represents a contract between an investor and a startup, allowing the investor to invest money in exchange for the right to receive equity in the company at a later funding round or triggering event.

Unlike traditional convertible notes, SAFE notes do not accrue interest, and their conversion into equity is typically based on a predetermined valuation cap or discount.

Traditional funding methods, such as convertible notes and equity, come with their challenges. Convertible notes may have complex terms and accrue interest, potentially leading to negotiation difficulties during subsequent funding rounds.

Equity issuance, on the other hand, immediately dilutes the ownership of existing shareholders, impacting the startup’s valuation and the founder’s control.

Advantages of SAFE Notes:

1. Simplicity and Flexibility: SAFE notes offer simplicity and flexibility in comparison to convertible notes and equity. The absence of interest accrual and the straightforward conversion terms simplify negotiations, making the fundraising process more efficient and less complex.
2. Protection for Both Investors and Startups: Investors benefit from the potential upside of equity ownership without immediate dilution, while startups gain access to capital without the immediate burdens associated with interest payments or significant equity dilution.
3. Common Usage in Early-Stage Funding: Their simplicity and investor-friendly features make them attractive instruments for startups seeking initial capital without the complexities associated with traditional financing methods.

SAFE notes have become a popular instrument in the early-stage financing landscape due to their simplicity, flexibility, and the balanced protection they offer investors and startups. By addressing the limitations of traditional funding methods, SAFE notes have become a preferred choice for many parties involved in early-stage investments.

Components of a SAFE Note

Many moving pieces come into play when creating and executing a SAFE note. Before you use this instrument, it’s important to be well-versed in what the major components are, what role each one has to play, and how to properly use it in negotiations.

Valuation Cap:

The valuation cap in a SAFE note sets the maximum valuation at which the investor’s investment converts into equity during a future financing round. It’s designed to protect early investors from potential high valuations, ensuring they receive a favorable conversion rate.

For instance, if an investor has a $5 million valuation cap and the subsequent funding round values the company at $10 million, the investor’s SAFE note will convert at the predetermined $5 million cap, providing a more favorable conversion rate than if there were no cap.

Discount Rate:

The discount rate in a SAFE note represents the percentage reduction from the price per share paid by the next equity investors. It determines the conversion price at which the SAFE note converts into equity, offering early investors a discount as a reward for their early support.

For example, with a 20% discount rate, if the next equity investors buy shares at $1 per share, the SAFE note holders would convert their investment at $0.80 per share. This discount provides an incentive for early investors who take on more risk during the early stages of a startup.

Conversion Trigger Events:

Conditions for Conversion to Equity: Conversion trigger events specify the conditions under which the SAFE note converts into equity. Common conversion triggers include equity financing rounds and acquisition events.

For instance, if the startup raises a subsequent round of financing exceeding a specified amount, the SAFE note may convert into equity at the predetermined terms. Similarly, if the startup is acquired, the SAFE note may convert into the acquirer’s equity.

The components of a SAFE note, including the valuation cap, discount rate, and conversion trigger events, work together to establish the terms under which the investment converts into equity. These components provide clarity and protection for both investors and startups in the dynamic landscape of early-stage financing.

Comparison with Other Funding Instruments

There’s a wide range of funding instruments and a SAFE note is just one of them. Each of them has pros and cons so it’s important to have a basic understanding of the options available before making a choice.

Convertible Notes:

SAFE notes differ from convertible notes in several ways. While both are debt instruments that convert into equity, convertible notes typically accrue interest and have maturity dates, adding complexity to negotiations during subsequent financing rounds.

In contrast, SAFE notes are designed to be simpler, with no interest accrual and a more straightforward conversion mechanism.

The shift towards SAFE notes is attributed to their simplicity and investor-friendly features. Negotiations with convertible notes often involve discussions about interest rates and maturity dates, introducing complexities that SAFE notes seek to avoid. SAFE notes have gained popularity in the startup ecosystem due to their straightforward terms and efficiency in early-stage fundraising.

Traditional Equity Financing:

Traditional equity financing involves selling a percentage of ownership in the company in exchange for capital. This method results in immediate dilution for existing shareholders, impacting the ownership structure and control of the founders. In contrast, SAFE notes delay the determination of the conversion price until a future financing round, providing a level of protection against immediate dilution.

Startups may opt for traditional equity financing when they have a clear valuation, established track record, or when they are at a later stage of development. However, if a startup is in the early stages, has uncertain valuations, or wishes to postpone dilution until a future round, SAFE notes may be more attractive. The choice often depends on the specific needs, stage, and strategic goals of the startup.

Revenue Financing

Revenue financing is a method of getting funding for your business by receiving an advance for a portion of your yearly revenue. Depending on the financing partner chosen, you can receive anywhere from 30% to 70% of your annual revenue upfront.

The major difference between revenue financing and SAFE notes is that revenue financing doesn’t impact your equity. It’s closer to a loan rather than a form of equity financing. While SAFE notes don’t immediately turn into lost equity, it happens eventually.   

Many startups with decent revenues are taking this route to reduce equity dilution in the early days and accelerate growth with an injection of cash. The drawback of this method is that you need revenue and a clear performance history so your risk profile can be assessed.

The comparison of SAFE notes with other funding instruments like convertible notes and traditional equity financing reveals distinct features and considerations. SAFE notes stand out for their simplicity, flexibility, and delay in the determination of conversion prices, making them a popular choice for early-stage startups seeking efficient and investor-friendly funding mechanisms.

How to Use SAFE Notes

Drafting and Negotiation:

When using SAFE notes, key terms include the valuation cap, discount rate, and conversion trigger events. Entrepreneurs and investors need to carefully negotiate these terms to ensure a fair and mutually beneficial agreement.

Clear language regarding the conditions triggering conversion and any investor protections is crucial for a well-drafted SAFE note.

Legal professionals play a vital role in the drafting and negotiation of SAFE notes. Experienced attorneys can help both parties understand the implications of each term, ensure compliance with legal requirements, and facilitate a smooth negotiation process. Their expertise ensures that the document is legally sound and aligns with the intentions of both parties.

Examples of Successful Implementations:

Numerous startups have successfully utilized SAFE notes for fundraising. Y Combinator, the accelerator that introduced SAFE notes, has seen widespread adoption among its portfolio companies. Dropbox, for example, used a SAFE note in its early days, contributing to its success.

Lessons learned from successful implementations include the importance of clearly defining conversion trigger events, setting reasonable valuation caps, and maintaining transparency in negotiations.

Best practices emphasize the need for startups to educate investors on the benefits of SAFE notes and for investors to conduct due diligence on the startup’s potential for success.

Using SAFE notes involves a careful process of drafting, negotiation, and legal consideration. Key terms and conditions must be clearly defined to create a fair agreement. Legal professionals play a crucial role in guiding both parties through the process. Successful implementations showcase the effectiveness of SAFE notes in fostering early-stage fundraising, with lessons learned and best practices providing valuable insights for entrepreneurs and investors alike.

Risks and Challenges

Potential Drawbacks of Using SAFE Notes:

1. Investor Concerns: Investors may have concerns about the lack of interest payments associated with SAFE notes, as they do not accrue interest like traditional convertible notes. Additionally, the simplicity of SAFE notes may raise apprehensions for some investors who are accustomed to more complex instruments.
2. Impact on Future Funding Rounds: The use of SAFE notes can impact future funding rounds, especially if subsequent investors are unfamiliar or uncomfortable with the terms. The delay in setting a valuation until a future event may lead to challenges in determining the appropriate conversion price, potentially affecting the attractiveness of the investment.

Mitigation Strategies:

1. Addressing Concerns through Negotiation: Open and transparent negotiation is crucial for addressing investor concerns. You can provide additional information, clarification, or assurances to investors to mitigate their apprehensions. Engaging in honest and collaborative discussions during the negotiation process can help align expectations and build trust between the parties.
2. Balancing Risks for Both Parties: Mitigating risks involves striking a balance that benefits both startups and investors. Consider setting reasonable valuation caps and discount rates to make the terms more appealing to investors while ensuring the startup’s financial health. Clear communication about the rationale behind the chosen terms and how they align with the startup’s growth strategy can help build confidence among investors.

The use of SAFE notes comes with potential drawbacks, including investor concerns and impacts on future funding rounds. Mitigation strategies involve addressing these concerns through transparent negotiation and finding a balance that minimizes risks for both parties.

By fostering open communication and understanding during the negotiation process, startups can navigate the challenges associated with SAFE notes and build strong relationships with investors.

Conclusion

As mentioned in this guide, a SAFE note is a funding instrument that allows people to invest in a company now but receive equity and a valuation that’s to be determined in the future.

Generally speaking, it’s simple and protects the interests of both startups and investors while providing capital to grow the business early.

You now know the components of a SAFE note and how they stack up with other funding vehicles available to you. It’s up to you to decide whether or not it’s right for your situation.

Let me know what you think in the comments and don’t forget to share.