SAFE Note Explained. SAFE vs Convertible Note
What Is a SAFE Note?
SAFE notes (or Simple Agreement for Future Equity) are a simpler option than convertible notes. SAFE notes are documents that early-stage companies use to help raise pre-seed or seed capital. Essentially, a SAFE note acts as a legally binding promise to allow an investor to purchase a specified number of shares for an agreed-upon price at some point in the future. In simple terms, an investor will give a startup money and receive a promise to get equity, usually at a predetermined price when certain milestones are met.
Key Elements in a SAFE Note: Valuation Cap and Discount
SAFE notes have a few main terms that change how they finally convert to company shares, and they are:
- Discount: SAFEs sometimes apply discounts, commonly between 10% and 30%, on future converted equity. It means that the investor will be able to buy shares at a discount on the future financing. For instance, if the company offered SAFE note holders a 20% discount and reached a valuation of $10 million, with shares available to new investors at $10, the SAFE investors will be able to purchase their shares at $8, thus receiving a 20% discount.
- Valuation Cap: Alternative way for the investor to receive a better price per share than future investors is through a valuation cap. Valuation cap is a term in SAFE notes that sets the highest price per share, or cap, that can be used when setting the conversion price.
- Most-Favored Nation Provisions: In cases where there are multiple SAFEs, this term requires that the company informs the first SAFE about it, including the terms for the subsequent note. If the first SAFE holder finds the second SAFE’s terms to be more preferable, he or she can ask for the same terms.
- Pro-Rata Rights: Pro-rata, or participation rights, allow investors to invest additional funds so that they can keep their percentage of ownership during future equity financing.
- Four Types of SAFE notes:
valuation cap, no discount
Discount, no valuation cap
Valuation cap and discount
MFN, no cap, no discount
Pros and Cons of SAFE
SAFE notes and convertible notes are good options, and there are good reasons to use either. The option that is the most popular in your community (so investors feel comfortable) it’s usually the best to choose when seeking a seed round. SAFE pros and cons:
Pros:
- Simplicity: A SAFE note is simpler than a convertible note. It has no end date or interest. You may even be able to understand and draft one without a lawyer’s help. It will be straightforward with clear perks and downsides.
- Have Simple Accounting Requirements: SAFE notes are included in a company’s capitalization table, removing the need for any complicated tax consequences.
Cons:
- Risks to investors: SAFE notes are not an official debt instrument. This means there is a chance they will never convert to equity and that repayment is not required.
- Don’t Provide Dividends: A lot of companies provide dividends, either in the form of payments or additional shares, to investors when the company performs well. In most cases, SAFEs don’t supply investors with dividends. Instead, an investor’s reward for investing in a SAFE is equity.
- Lower returns: Accruing no interest on a short-term investment is not a big deal. However, if you hold an investment for over a year, it could make a huge difference. Accrued interest gives note holders a greater return on their investment and creates an incentive for a company to close an equity round.
- Dilution: Many investors don’t think about the potential impact that these notes may have on the valuation of the business in the future. They may overlook the potential dilution implications.
- Lack Minimum Requirements: SAFEs don’t have a minimum requirement for equity to enter conversion, which can have a negative impact on future investments. Minimum requirements allow you to readjust the note’s terms, giving smaller investors the opportunity to compete.
SAFEs vs Convertible Notes
Similarities:
Eventually, they both can be converted to equity. They transform into equity in a future priced round (equity round).
SAFE notes and convertible notes can both offer a discount and/or a valuation cap on an upcoming round (or a current round in the case of convertible notes). There’s no big difference in this case.
Difference between SAFE and convertible note:
Debt: SAFE notes are not a debt instrument whereas convertible notes are. Convertible notes are basically loans that need to be repaid. It can be repaid through cash or shares in the company.
Timeline: Convertible notes have maturity dates, unlike SAFE notes. After a period of time (typically 18–24 months), the convertible note automatically converts or must be repaid. SAFE notes can be held in perpetuity if the company doesn’t continue raising money.
Interest: Like most debts, convertible notes carry interest. The company must pay back the principal plus interest, or allow the total amount to convert into equity — which can give the investor a far greater share of ownership than what they first “paid” for. By contrast, because a SAFE note is a warranty, not a debt, it does not carry interest.
Paperwork: SAFE notes tend to be shorter and simpler than Convertible notes with fewer terms, provisions, and contingencies for both parties to work out. This is one of the primary reasons SAFE notes were invented as an alternative, and why they’ve become increasingly popular among founders and investors in recent years.
SAFE Note example
Below you can find an example of SAFE.
Safe note Y Combinator:
SAFE Note Calculator
A calculator for exploring the impact of SAFEs and convertible notes on founder ownership. You can find it by following the link below:
Understanding SAFE note math:
Why we don’t like it
We don’t like SAFE notes only as a Late Seed, Series A, Early Series B investor. Actually, SAFE note works for pre-seed and seed startups, when you have to raise money (raise new round) after SAFE or your company will die. However, now a lot of investors and startups start using SAFEs at late-stage investing. At a late stage, the company can live and don’t raise a new round, so SAFE notes can be held in perpetuity. If a new investor doesn’t come you will have to negotiate terms that you omitted before. Personally, I’m trying to discuss all terms before the round in order to be on the same page with founders.
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