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The startup founder and investor’s simple guide to SAFE notes
Posted by Grace Townsley
December 12, 2022
If you’re a startup founder looking for a simple way to secure venture capital money, or an investor looking for new opportunities, you’ve probably seen the term “SAFE notes” thrown around.
Should your startup issue SAFE notes to accelerate your growth? Or, if you’re an investor, should you consider investing in the SAFE notes of startups you believe in?
Read on to learn the benefits and drawbacks of issuing and investing with SAFE notes.
What are SAFE notes?
The “SAFE” in SAFE notes stands for Simple Agreement for Future Equity. SAFE notes allow early-stage startups to collect VC without the paperwork and hassles that come with a traditional VC fundraising round.
Conducting a round of VC funding requires finding a lead investor, potentially pulling several investors into a single round and dealing with complicated or limiting VC agreements that can reduce your control over your company. With SAFE notes, you typically only need to negotiate your valuation cap. That means founders can close SAFE investment deals, which typically come with 15% equity in the company, within a day.
SAFE notes also come with several exit options. Founders can choose to pay back the SAFE note by returning the funds to the investor.
If the company is sold, the notes can be paid back, often with an extra payout option for the investor. And if the founder isn’t ready to exit, the SAFE notes can be held in perpetuity— even long after the business turns a profit.
In addition to the freedom and flexibility SAFE notes offer founders, there’s another key benefit that makes them particularly appealing: They don’t become equity until a conversion event occurs, like a formal VC funding round, company sale or an IPO event. That allows founders to avoid diluting their ownership until they’re ready.
The basic terms you need to know when discussing SAFE notes
There are a handful of terms only used when discussing SAFE notes. If you’re considering issuing SAFE notes for your startup — or investing in them — here are some of the most common terms you’ll see:
Valuation cap. This is typically the only negotiable term of SAFE notes. It refers to the ceiling value given to the startup, which will be used to determine how much equity each investor has in the company when a conversion event occurs.
Discount rate. When an applicable conversion event occurs, the discount rate tells investors what rate they can purchase preferred stock at, compared to the going price. Not all SAFE notes come with a discount rate, as we’ll cover in the next section.
Conversion events. When SAFE notes are converted to equity shares, giving investors the agreed-upon amount of ownership in your company, this is known as a conversion event. The most common conversion events are financing rounds, IPOs, and company sales or dissolution events.
Dissolution events. This means the company has closed. Investors with outstanding SAFE notes may receive some compensation, depending on the funding the company has available.
Company capitalization. This refers to the total value of your business’ debt and equity combined.
While the individual terms of your SAFE notes, like the discount rate and valuation cap, can be negotiated on a case-by-case basis, meaning no two SAFE notes are exactly alike, most SAFE notes fall into one of two categories:
Pre-money SAFE notes. When you issue pre-money SAFE notes, your company’s capitalization does not include the funds you’ll receive when the SAFE note funding comes in. This number may be easier to calculate, but doesn’t allow founders and investors to determine how much ownership they’ll have once the deal goes through.
Post-money SAFE notes. This type of SAFE note is more common because it calculates your company’s capitalization includingthe funding you’ll receive when the deal closes. Both founders and investors can easily determine how much ownership they’ll have.
Investors utilize SAFE notes because of the upside potential
A big benefit of SAFE notes for investors is that when they convert (such as at the next round of funding, or when the company is sold) the notes convert to preferred stock. If the company’s valuation has increased since the SAFE notes were issued, the investor is able to secure this preferred stock at a discounted price.
Plus, because an investment deal using SAFE notes is easier to plan and negotiate than traditional funding rounds, interested investors can support the companies they believe in without facing the headaches that come with other forms of financing.
SAFE notes versus convertible notes
At first glance, SAFE notes and convertible notes seem similar. Both are fairly simple to set up, and both are activated at a later date.
However, convertible notes come with greater drawbacks. With convertible notes, founders are required to pay interest on the funds and the funds must be repaid by a certain date.
If a startup over-leverages convertible notes and is unable to make payments by the activation date, they can even face bankruptcy. For founders in search of a simpler VC process with fewer strings attached, SAFE notes can be the smarter option.
Limitations of SAFE notes
For startups, the biggest SAFE note limitation is the fact that typically, only corporations (not LLCs or sole proprietors) can issue them. This prevents many startups from seeking this form of funding.
Another drawback to issuing SAFE notes is that it may be difficult to find interested investors. SAFE notes are a recent tool startups have only begun using in the past few years. And if investors are unfamiliar with an investment tool, they may be less inclined to utilize it.
SAFE notes can be a smart funding tool for early-stage C corporation startups with a promising business. But as with any fundraising tool, it’s important to do your research before you begin reaching out to investors.
Want more? Since 2006, Escalon has helped thousands of startups lead with confidence with our back-office solutions for accounting, HR, payroll, insurance, and recruiting and taxes — and we can help yours too. Talk to an expert today.