Keep reading to learn all about how SAFE notes work.
Now that you started your company, what is the next step to make it successful? Do you have the money to run it or would you need some help? A lot of startups normally need some outside help when they start off. And if you have an investor’s interest in your project, the best way to get funding from them is by using SAFE Notes.
Why use them? Well, your company would most likely not have a high value in the beginning. Giving out equity at that time in place of funding would be difficult as you run the risk of giving away a lot of your ownership for some initial company funding. To avoid this, convertible notes were created. But after some time, people began to find the convertible notes very complicated and to make things simple, SAFE notes were created. In short, SAFE notes are a kind of convertible notes that promise the investor future equity in the company.
SAFE or Simple Agreement for Future Equity
A SAFE, also known as Simple Agreement for Future Equity, is a simpler alternative to convertible notes. This note allows you to take on investments that will convert into equity in the future. SAFE notes address a lot of the challenges and drawbacks that convertible notes posed, which makes it a great option for founders and investors.
SAFE notes were created in 2013 by Y Combinator, a Silicon Valley accelerator. They are designed to be simple agreements with about 5 to 10 pages in the document. They are a useful instrument to connect your investor and business. These notes come without interest rates or maturity dates, and the only negotiable detail in the note is the valuation cap. They are a lot similar to convertible notes, just that SAFE notes are much more simple and flexible.
Benefits of using SAFE Notes
When a company is at the initial stage, it usually does not have any high value of its own. So offering equity in exchange for funding may be a bad idea. That is why SAFE notes were created. There are a lot of benefits of using the SAFE notes, which include:
- Flexibility: SAFE notes offer a lot of freedom as there is no need to get a valuation done for the company. With no repayment obligations and maturity date, the owners can have peace of mind knowing that they don’t have to worry over cash flows and threats of insolvency.
- Simplicity: The most obvious benefit is that SAFE notes are simpler than convertible notes. It does not have any interest, a maturity date, and is just a 5-page document. The clauses are straightforward and clear allowing the deal to proceed faster than when using convertible notes where negotiations cause delays.
- Conversion to Equity: Investors get paid with future equity of the company. And even though there is no maturity date, there is a valuation cap. When the next round of equity is raised and preferred shares are distributed, that is when the SAFE noteholders would get their equity. This is fair for both the investors and founders.
- Provisions: SAFE notes offer provisions for early exits, dissolution of the company, or the change of control. There are also provisions for investors such as the valuation caps and discounts.
- Negotiation: Unlike other convertible notes, SAFE notes do not need a lot of negotiation. All they talk about during the deal-making is the valuation cap.
- Proportional benefits: When SAFE notes convert, the investor might be entitled to better benefits in proportion to their original investment, such as offering preferred stock. This can be a better deal than convertible notes, but it can also make for a more complicated mix of shares. So, remember to consult with your lawyer and tax expert.
SAFE vs Convertible Notes
Convertible securities are offered to investors who invest in early-stage companies. This means that both SAFE notes and convertible notes are similar. In fact, SAFE notes were created to make the transactions much faster and cheaper than convertible notes. But with this, SAFE notes have some risks as future negotiation and flexibility are lost. So, are convertible notes better? Let us discuss further.
SAFE vs Convertible Notes – Similarities
Let us talk about the similarities first:
- Both offer a discount on the upcoming round (or current round in case of convertible notes)
- SAFE notes or convertible notes can be obtained without a valuation cap.
- In case you are searching for an early exit, both offer similar mechanisms in the event of a change in control. SAFEs offer investors the choice of a 1x payout or conversion into equity at the cap amount to participate in the buyout.
- Normally, there are 2x payout provisions in a convertible debt agreement, which can still be written into SAFE agreements. Both options have seed investment advantages in this category.
- Both transform into equity in the future.
- Both have value maxims, savings, and most favored nation clauses.
- They also include the ability to get out early and have financial perks like discounts, and protections like valuation caps.
SAFE vs Convertible Notes – Differences
Both have differences including:
- Unlike SAFE notes, convertible notes permit you to change your current round of stock or your future financial situation.
) Convertible notes apply when a “qualifying transaction takes place”. This means that you can transfer them once an agreed-upon minimum amount is made or on a mutually agreed upon date. For SAFE notes, the conversion takes place when any number of investments are accrued. Therefore, there isn’t much control given to the entrepreneur with SAFE notes.
- SAFE notes are simpler than convertible notes as they do not have a maturity date and do not accrue interest. While the convertible notes can have an interest rate ranging from 2% to 8%, and a maturity date.
- SAFE notes are quick to finalize a deal. But convertible notes take longer, although they can be created faster with the help of a lawyer.
- Unlike SAFE notes, convertible notes sit at the top of the cap table but are flexible (“unsecured”), meaning investors can’t foreclose on the company’s assets.
- An investor who opts for a convertible note has an end date in mind (maturity date) and knows when they will be paid. But it also comes with an interest that the company has to pay to the investor, unlike SAFE notes.
Terms of SAFE you should know
There are a few common terms of SAFEs that can change how they convert to shares in the company. The four main terms include discounts, valuation caps, most favored nation provisions, and pro-rata rights. Each has been explained below:
A SAFE note can have a discount on the share price of future capital raising. This is normally to appreciate the risk taken by the investor by investing in an early-stage company. Discounts are normally in the range of 10% to 30% but it can be more if the investor is offering other benefits or services to the company. For instance, let us say that the SAFE offers a discount of 20% and the company undertakes a priced capital raising at $3.00 per share, the SAFE note would convert using the share price of $3.00 x 80%, which will be $2.40 per share.
#2 Valuation caps
A valuation cap is a maximum valuation at which the cash investment made will convert to shares. It is an investor-friendly provision as it secures the investor from getting a smaller number of shares if the valuation of the company increases significantly. For instance, let us say that a SAFE includes the valuation cap of $2M and the company takes outside funding at the valuation of $4M, the SAFE note will convert based on a $2M valuation.
#3 Most favored nation provisions
To explain this, let us take an example and assume that a SAFE has an MFN provision. In case another SAFE note is issued, the company will have to tell the initial investor about it. In case the terms of the second SAFE are better for the investor as compared to the initial SAFE, then the investor can ask for the same terms. This is called most favored nation provisions.
#4 Pro-rata rights
Pro-rata also means participation rights. And with this, an investor can invest additional funds to maintain their ownership percentage during the equity financings after the financing round where the SAFE was converted to equity. By exercising the pro-rata rights, the investor pays the new price of the round rather than the price they paid when the SAFE initially converted.
Types of SAFE Notes
With the terms for SAFE notes clear, let us now talk about the kinds of notes that are there based on these terms. Since there are only two negotiating points of SAFEs, there are just a few types. These include:
- cap, no discount – The SAFE notes have only a valuation cap and no discount.
- no cap, discount – The SAFE notes do not have a cap, but have a discount on the future price of the share when the note converts.
- cap and discount – There are SAFE notes where they have both a valuation cap and a discount.
- MFN (most favored nation), no cap, no discount – There is also a kind of SAFE note where there is a MFN, but no discount or valuation cap.
How a SAFE Note Works
From the above you now know what a SAFE note is and all the terms of a SAFE note. With this said, let us now understand how SAFE notes work. SAFE notes permit an investor to issue shares in a future priced round. This means that there is no specific share price determined at the time the funding is raised. So, with this, the investor would be able to convert the amount invested into equity through the SAFE note once a pre-agreed trigger event occurs.
This pre-agreed trigger event is normally the next priced equity round by the company, ie. the next funding round. The advantage of this is that you can defer the valuation of your company to a later date. The number of shares that the investor receives would be based on the amount they paid upfront and the share price of the priced equity round or liquidation event.
But what if the company fails?
Well, if the company fails, all the money left in the company has to be returned to the investors. Also, the founders do not have to pay money from their pockets but from the company’s pocket back to the investors.
And what if the company grows?
For a growing startup, the company is very likely to raise more money. So, this means that you will get the SAFE notes converted. And the best option is to always consider a conversion way into the future since the risk is also high for investing in a startup.
Let us take an example where Kelly invests about $30,000 in a company through a SAFE. The company will use this money to now build the business. But just to be clear, $30k isn’t a lot. So, once the company makes a bit of progress, they would want to raise more money. At this time, let us assume that the company has reached the value of $7M and they find an investor who agrees to invest $3M into the company. If 30% of the money is worth the $3M after they invest, that means that the post-money valuation is $10M.
To put this in calculation: Pre-money valuation + new money = post-money. This would be $7M + $3M = $10M.
To get the ownership stake of this new investor, the formula would be: (new money/post-money) * 100% = ($3M/$10M) * 100% = 30% ownership stake.
Now, if we assume that the company had only 7M shares before the $3M financing, the price of the new share would be calculated as: pre-money valuation/pre-money fully diluted capitalization = ($7M/7M shares) = $1.00 per share. So, now that we have the price of the share, we can do the conversion of the $30K SAFE notes. And assuming that there is no discount and no valuation cap, the $30K SAFE will turn into 30,000 shares in the company.
|Post Money Valuation||$10,000,000|
|Pre-money fully Diluted Shares||30,000 shares|
|Converted Shares from SAFE Note||30,000 shares|
From the table, it is clear that once the funding round had taken place, that is when the SAFE converted into shares. This means that Kelly, who was the initial investor in the business, ended up with 30K shares for the SAFE agreement she received.
Tax Treatment for SAFE Notes
When it comes to taxes, the investors in a company who receive SAFE notes have to pay an annual fee for it. Although it can be explained better by a lawyer or tax expert, generally speaking, an investor will have a specific tax holding period. The period would begin when the SAFE notes are used, that is when the notes are converted to equity.
Even with that wait, the holding period from the conversion to the first equity round is longer than a single year. There’s no advantage to holding for more than a year, so the investor won’t be reprimanded or lose out in any way. If there is a non-cash sale of the company in which the investor invested or if there is a sale within a year in which they invested, they would lose here.
With that said, some investors gaining seed money will aim for a five-year holdout for their notes since this may help them merit the Small Business Stock Gains Exclusion under Section 1202 of the U.S. tax code. The IRS has yet to clarify how it will work, but as of now, it seems it will be very much like a warrant sale.
Create SAFE Notes on Eqvista
Now that you know all about SAFE notes, if you are planning to use it, you need to keep a record of it as well. The best way to do this is by using a cap table application like Eqvista.
In fact, you can easily create SAFE notes on Eqvista and issue it to an investor. Here is an image showing how you can create and fill in the details of a SAFE convertible note on Eqvista.
Once you fill in the details and click on “Submit”, you will have created the SAFE notes and will reach the page where you can see it as shown below.
Eqvista also helps you in seeing how the SAFE notes will affect the cap table and even dilute the other shareholder’s (founders) ownership once there is a funding round in the company. This can be viewed with the help of the round modeling tool. You will need to select the post-money option in this tool to see the effects, as shown below.