SAFE Notes
  • 02 Jul 2019
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SAFE Notes

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Simple Agreement for Future Equity, which can act as a replacement for convertible note financing, was created by YC combinator in 2013.

A SAFE is a simpler alternative to convertible notes, allowing startups to structure seed investments without interest rates or maturity dates.

Four Types of SAFE notes

  • Cap, no discount
  • Discount, no cap
  • Cap and discount
  • MFN, no cap, no discount

Pros of SAFE notes vs Convertible notes:

  • Simplicity: A SAFE note is simpler than a convertible note. It has no end date or interest and is only a five-page document. You may even be able to understand and draft one without a lawyer's help. It will be straightforward with clear perks and downsides.
  • Less to negotiate: Unlike other investments, SAFE notes do not require much negotiation. Sometimes valuation caps are talked about, but that's all.
  • Accounting: Like other convertible securities, SAFE notes end up on a company's capitalization table.
  • Similar provisions: SAFE notes still make provision for early exits, change of control, or even the dissolution of a company. There are provisions for investors, such as discounts and valuation caps.
  • Conversion to equity: Investors can change their investment to equity later. The date of conversion is not predetermined, but it can happen when an equity round is raised and preferred shares are distributed.
  • Flexibility for startups: The lack of pre-defined terms and a maturity date gives the startup total freedom with no specific destination or expectation.
  • Proportional benefits: When SAFE notes do convert, you may be entitled to better benefits in proportion to your original investment. They can offer preferred stock, called "shadow" or "sub-series" stock. This can be a better deal than convertible notes, but it can also make for a more complicated mix of shares. Watch out for legal costs during equity rounds.

Cons vs Convertible notes:

  • 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.
  • Incorporation requirement: A company must be incorporated to offer SAFE notes, and many startups are LLCs. That means a company will have go through the incorporation process before being able to issue SAFE notes, which may require the services of an attorney.
  • Lack of familiarity: SAFE notes are relatively new, which means lawyers and investors have less experience with them. Convertible notes are more established and may be more attractive to investors.
  • Fair valuation expenses: SAFE notes may trigger the need for a fair valuation (409a). A company may need to allocate funds for professional services, leaving less available for product development.
  • Legal jargon: Some people say that SAFE notes appear simple, but they are not. The document is five or six pages long, which is not short. Other people feel that the sections with legal language are hard to comprehend and that it is almost or equally as difficult to understand as any other legal document.
  • Distribution of dividends: Because of a loophole, dividends do not have to be paid to SAFE note holders the way they are paid to common shareholders. However, since the real purpose of a SAFE note is not to be repaid but to gain equity, investors may be comfortable with this arrangement.
  • 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.
  • No minimum requirement: With SAFEs, there is no minimum requirement for an equity round to go into conversion. However, a minimum can actually be helpful because it lends the round legitimacy and value. It means that a SAFE note can be re-adjusted on a whim and that a smaller investor can negotiate a better deal and compete.
  • Less favorable variations: Two of the four types of SAFE notes do not offer a discount, and two don't give a valuation cap. Those that have both โ€” which puts the investor and founder on the same footing โ€” require more negotiation.
  • 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.

Negative Aspects of SAFE Notes:

We have observed the following in our own recent direct experience investing in SAFE and convertible notes: that many founders have a tendency to associate the valuation cap on a note with the future floor for an equity round; that they further assume that any note discount implies the minimum premium for the next equity round; and that many founders donโ€™t do the basic dilution math associated with what happens to their personal ownership stakes when these notes actually convert into equity.

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