SAFE is an acronym for Simple Agreement for Future Equity. For us, anything that has the word ‘simple’ is already winning! At Cake, it’s all about simple and fast.
In the world of startup funding, founders are always on the lookout for simple, fast, and creative ways to raise capital. It is for this reason that Y Combinator introduced SAFE notes in 2013, providing startups with a simplified way to structure seed investments, eliminating the need for interest rates, maturity dates, or valuation caps.
Since then, SAFE note agreements have risen to popularity, with tech start-ups in Silicon Valley using them frequently. Although SAFE notes are originally designed with US laws and terminologies, we have seen them localised and adapted in Australia, Asia, UK, and every where in the world.
In this comprehensive guide, we will deep dive into the intricacies of SAFE notes, how they work, pros and cons, and how to leverage them for your startup.
SAFEnotes, explained
What is a SAFE note
SAFE note, also known as a Simple Agreement for Future Equity, is a type of investment contract commonly used by startups to raise capital from early-stage investors. With a SAFE agreement, you can secure funding for your startup while offering investors the right to convert their investment into equity in the future.
SAFE notes are simple and fast, without the pressure of interest payments, maturity dates, or valuation caps. It is a type of convertible security, similar to an option or warrant, which grants the investor the opportunity to purchase shares of preferred stock in a future priced round.
Startups may find SAFE notes appealing because, unlike convertible notes, they do not incur debt and therefore do not accumulate interest. It is important to note that SAFE notes do have some limitations that entrepreneurs should consider, as they can come at a high cost.
How does a SAFE note work
A SAFE note is a financial instrument used in startup investing that allows investors to provide capital to a startup in exchange for a promise of future equity, hence the term Simply Agreement for Future Equity.
There are two key components of a SAFE note: the valuation cap and the discount rate.
Valuation Cap
The valuation cap sets the maximum valuation at which the investor's investment will convert into equity. It is designed to protect the investor from excessive dilution in subsequent financing rounds.
While valuation caps are not required for SAFE Notes, they are often included. Just like with convertible notes, the valuation cap sets a maximum conversion price for the cash to convert into shares. This will often be the point of interest in negotiation for the investor, where they seek to better control the stake they can to receive on conversion.
In simple terms, a valuation cap works by allowing the investor’s equity to be priced at the lower of the valuation cap, and the Company valuation in the subsequent fundraising round. Valuation caps typically range from $3M to $10M for seed stage startups.
Discount rate
The conversion discount allows the investor's investment to convert into equity at a discounted price compared to the price paid by new investors in a future financing round. This incentivizes early-stage investment and compensates investors for taking on higher risk.
Types of SAFE notes
- Cap, no discount. Includes a maximum valuation, but no discounted price per share.
- Discount, no cap. Offers a discounted price per share, but no maximum valuation.
- Cap and discount. Combines a maximum valuation and a discounted price per share.
- Most Favored Nation: no cap, no discount: Entitles the investor to the same terms as subsequent investors without a cap or discount.
These variations provide different benefits and considerations for both startups and investors. It's important to consult legal and financial professionals to understand the implications of each type and determine the best fit for your specific situation.
Other important components of SAFE notes are the conversion details and investor rights.
Conversion or trigger event
The conversion or trigger event is the event that initiates the conversion of the SAFE Note into equity. It is typically tied to a subsequent financing round, such as the issuance of preferred stock or a specified amount of funding raised by the startup.
As there is no loan element in a SAFE Note, there is no interest rate or maturity date. This means there is
- no need to keep track of upcoming deadlines in relation to the loan, and
- subsequently, no need to request that the investor extends the maturity date (to meet some fundraising round before it occurs).
Therefore, if the Trigger Event never occurs? Well, then the cash is never paid back.
In reality, even with convertible notes, it is quite rare that the loan is actually paid back in cash. Usually, the loan is converted into shares, and if not, it is often because the Company has become bankrupt, so the Investor will be claiming its funds as a creditor that way.
Investor Rights
While SAFE notes are generally founder-friendly, investors may negotiate certain rights to protect their investment. These rights may include:
- Pro-rata rights. This gives the investors the right to participate in your next funding round at the same percentage they own through their SAFE notes.
- information rights. This grants investors access to the startup's financial and operational information.
- Liquidation rights on insolvency. Usually, SAFE notes will include a term requiring the company to pay the investor back the amount equal the cash injection on insolvency, before making payments to any shareholders.
Keep in mind that great investors are familiar with SAFE notes and know their way around these rights. You want to make sure that you understand these rights and bake them into your agreement.
When to use a SAFE note
A SAFE note and a convertible note are both types of financial instruments used in startup fundraising. The decision to use SAFEs or convertible notes depends on various factors, including the goals and preferences of both the startup and the investors.
Here are some scenarios where one might choose a SAFE over a convertible note:
When you need something simple and fast
SAFE notes are generally simpler and quicker to execute compared to convertible notes. They have fewer terms and conditions, making the fundraising process faster and more streamlined. If speed and simplicity are important, SAFE notes might be preferred.
When valuation is uncertain
SAFE notes are often used when the valuation of the startup is uncertain or difficult to determine. In the early stages of a startup, determining a fair valuation can be challenging, and a SAFE note allows investors to defer the valuation discussion until a later funding round. This can be advantageous for both the startup and the investors.
When in early stages
SAFE notes are commonly used for seed-stage or early-stage fundraising. At this stage, the startup may not have enough financial data or a solid valuation, making a SAFE note a more suitable instrument. Convertible notes are often used in later stages when the startup's valuation is more established.
There's really good reasons to use them in early days, both from the startup and the investor side. It's a way to help the startup and the founders get moving. They maybe got some early traction, but they really need to demonstrate more traction to bring in the funds [...] So that gets you on your way and then you have a good idea of what the next round will be.Or I would use it in a case where, you need a quick bridge to the next round. You might've been talking to a lead. They're very interested, but you just need to put a little bit more fuel on the fire, or you just need to extend the runway a little bit.
—Quentin Wallace, Co-founder andPartner atArchangel Ventures
The choice between a SAFE and a convertible note ultimately depends on the specific circ*mstances and negotiation between the startup and the investors. Consulting with legal and financial professionals experienced in startup fundraising can help make an informed decision based on the unique needs and goals of the parties involved.
Step-by-step
How to issue SAFE notes in your startup
The first step is all about finding the right investors who are willing to be in a SAFE agreement with you. Once you have an investor lineup,
1.Define the terms
Determine the key terms of your SAFE notes. This includes the amount being raised (or the "raise goal"), the valuation cap, and the discount rate. You’ll also want to specify trigger events and investor rights. Best if you get input from your legal counsel when defining these terms.
2.Create the SAFE note agreement
Once you’ve settled on the terms, you need to draft the actual SAFE note agreement. This is a legal contract between your startup and the investors purchasing the notes. Typically, you also work with your legal counsel to make sure all required disclosers are included and the agreement complies with country-specific regulations. You can also use Cake's SAFE note agreement template.
Cake comes built-in with SAFE note agreement template that you can use as is, or customize with inputs from your lawyer. You just need to provide your raise goal, valuation cap, and discount rate, and a standard SAFE note agreement will be generated for you.
3.Issue notes and collect funds
As investors commit to purchasing SAFEs, you need to have them sign the SAFE note agreement. With Cake, issuing SAFE notes and collecting funds is fast and simple.
I was surprised at how quickly a round came together using SAFEs. I had this vision and I'm going to have to do a priced round. Using SAFEs and Cake, it just created momentum so much quicker. Using SAFEs in conjunction with Cake, it's like I've had a tougher time getting RSVPs to in-person events than getting investors to sign on because it just like made the process, templated and quick and, and, and sort of seamless. Once everything was set, it just, it just went so smoothly.
—Joshua Ismin, Co-founder and CEO at Psylo
Make sure you have every SAFE note issued are recorded in your cap table. Investors like having transparency and knowing that proper documentation are in place.
Having a software like Cake lets you start a SAFEnote raise fast and easy, while managing the tedious legal and admin aspects.This is extremely beneficial for both startup founders and investors. See for yourself. Get started today for free.
4. Convert to equity
When all goes well, you’ll go on to raise a priced equity round and the SAFEs will convert to equity at the specified discount. The SAFE note holders will then become shareholders. SAFE notes provide startups flexibility, but also the responsibility to properly manage the fundraising and ensure obligations to investors are fulfilled.
Following these essential steps will allow you to successfully raise capital through SAFE notes while building great relationships with early investors in your startup. Be transparent, thoughtful, and committed to honoring the terms of the notes, and SAFE notes can be a win-win for startups and investors alike.
SAFEnotes vs Convertible notes
How SAFE notes differ from convertible notes
When considering fundraising options for your startup, it's important to understand the key differences between a SAFE and a convertible note. While both instruments serve as investment contracts, they have distinct characteristics that can impact your fundraising strategy.
A SAFE note agreement differs from a convertible note in several aspects. Some key differences are the following:
- Interest rate and maturity date. Unlike convertible notes, SAFE notes do not involve an interest rate or maturity date.
- Repayment obligation. SAFE notes also lack an explicit repayment obligation, making them more favorable for startup founders.
- Equity vs debt. SAFE notes prioritize the future conversion of investment into equity, while convertible notes often prioritize debt repayment.
Long story short – SAFE notes are just like convertible notes, but with even less complexity.
Although they could be considered slightly more risky for the investor, the reality is that most investors never set out to be ‘lenders’ anyway. And in fact, many are actually more open to a cash injection. This option may also provide accounting or tax benefits for the investor.
Why pick a SAFE note instead of a convertible note?
One benefit of the convertible notes was the time they save on negotiation.
Basically, the SAFE note avoids one further topic of negotiation between the Company and the Investor – terms relating to the loan.
SAFE notes do not have a loan (debt) element, so they therefore do not need to address the interest rate, the maturity date, and whether any collateral needs to be applied. Instead, an investor makes a cash payment in return for a contractual right to convert that payment into shares.
Quick-fire Q&A
FAQs on SAFE notes
Can I negotiate the terms of a SAFE note agreement with investors?
Yes, as a startup founder, you have the opportunity to negotiate certain terms of SAFE notes, such as the valuation cap, conversion discount, and investor rights. It is essential to strike a balance that protects your startup's interests while attracting potential investors.
Is a SAFE note suitable for all startups?
SAFE notes are commonly used by early-stage startups anticipating future fundraising rounds. However, the suitability of a SAFE depends on your startup's specific circ*mstances and your fundraising goals. Seeking guidance from legal and financial professionals will help you determine the most appropriate funding structure for your startup.
Can SAFE be converted into equity before a subsequent financing round?
In most cases, SAFE notes can only be converted into equity during a subsequent financing round or a triggering event specified in the agreement. However, the terms of each agreement may vary, and it is crucial to review the specific provisions outlined.
Are there any risks associated with utilizing SAFE notes for fundraising?
As with any investment, there are inherent risks associated with fundraising through SAFE agreements. It is essential to conduct thorough due diligence on potential investors and evaluate the risks and rewards before accepting funding offers.
This article is designed and intended to provide general information in summary form on general topics. The material may not apply to all jurisdictions. The contents do not constitute legal, financial or tax advice. The contents is not intended to be a substitute for such advice and should not be relied upon as such. If you would like to chat with a lawyer, please get in touch and we can introduce you to one of our very friendly legal partners.
