SAFE Notes
A SAFE is a promise to issue a certain number of shares in the future – “Simple Agreement for Future Equity.”
Created by the Silicon Valley-based Accelerator Y-Combinator, SAFE Notes were designed to speed the process and radically reduce the legal costs for the first round of growth company funding.
SAFE Notes vs. Convertible Notes
Startups that have not yet figured out their product and business model may choose to raise capital through SAFE notes, which only grants investors the right to invest in a future found of funding.
Unlike a convertible note, a SAFE is not debt, and so it has no deadline for repayment and no interest rate.
Convertible notes are technically debt that converts into equity once the company is able to raise more funding. But SAFE notes, designed to be founder friendly, do not have a mechanism for repayment if the founder does not raise additional capital
A SAFE grants the right to receive a certain number of shares in the next financing. Since SAFE investors are investing earlier and taking more risk than later-stage Seed or Series A investors, the SAFE investors will pay for their shares at a lower price than the Series A investors. The Valuation Cap and Discount Rate control how big a discount the SAFE investors get. While the discount and cap numbers mentioned provide an indication of the value of the company, the startup can avoid costly legal fees and the formality of valuation to speed up the deal negotiation process.
Example Accelerators SAFE Notes
Y Combinator | Additional Accelerators following Y Combinator’s lead
Are SAFE Notes the right capital for your business at this stage?
COMPANY PERSPECTIVE
Benefits
- Simple to document legally, administration is less expensive than a convertible note or equity investment
- Speed and access to capital
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No change in voting rights
Startup management can decide how to spend and plan investment without investor input
Challenges
- Founders do not accurately account for the "valuation math" when SAFE notes do convert to equity are are disappointed with less ownership
- Misalignment of incentives may create conflict and encourage companies to seek out a higher valuation in order to dilute early investors
- When an equity round is inevitably priced, entrepreneurs may be frustrated with dilution numbers at all
Key Performance Indicators
- Discount Rate
- Valuation Cap
CAPITAL GIVER PERSPECTIVE
Benefits
- Fast negotiation, standard terms
- Many high potential fast growth companies in competitive startup regions like the Bay Area, Boston, and NYC prefer SAFE notes over Convertible Notes and equity
- An option bet on a high risk but high potential company
Challenges
- No actual ownership rights are negotiated
- Startup management has full decision authority for how to spend the funds
- Many SAFE notes do not specify what happens if the company cannot or chooses not to raise subsequent equity financing
Key Performance Indicators
- Discount Rate
- Valuation Cap
When it Works Well
Speedy transaction
In startup ecosystems where this structure is in use, the SAFE Note is well known and built into accelerator structures, encouraging all early stage angels to see the first check as an options bet on the next round.
Legal fees are minimized and the funding round can be quickly closed as well, unless the company is not yet set up as a C-Corporation.
Funding before traction
For founders building software startups, there is an early development stage that usually precedes generation of evidence of customer demand, or financial results.
The lack of pre-defined terms and a maturity date gives the startup total freedom with no specific destination or expectation.
If founders are unable to move to product-market fit, they are encouraged to redeploy their high potential back to a new concept and try again. Investors write off the failure as part of the cost of high risk early stage investing.
This style and expectation of investors is prominent in the Bay Area and major startup hubs like NYC and London, but may not be true in other parts of the world.
Company is ready to be a C-Corp
SAFE notes require C-Corp status because the investment is noted on a capitalization table just like stock options.
Many startups are LLCs in the US, so companies have to go through the incorporation process before being able to issue SAFE notes, which may require the services of an attorney.
When SAFE notes convert, founders may be entitled to better benefits in proportion to the original investment. Founders may be entitled to preferred stock, called “shadow” or “sub-series” stock.
The recent turn to “exit to community” to transfer ownership to employees or other stakeholders is often in conflict with the C-Corp structure and investors. Make sure you understand the different types of organization before you sign up for a C-Corp.
Challenges to SAFE Notes
Big risk 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.
They are great for Angel investors who write many checks and are able to manage a portfolio of investments, and afford to have the majority fail with the hopes of one breakthrough growth story.
They are not ideal for investors who want a high confidence of return.
Dilution, Cap Table math confusion
Many investors, founders, and VCs don’t really understand valuation (shocking! but we’ve seen the math miscalculated frequently).
Understand what a capitalization table is, and determine what the dilution to your ownership will be upon a successful future fundraise. The more shares early investors agree to purchase, the less of your company you eventually own when the notes convert. That means less control over your organization’s future. It also means you’ll have a harder time attracting your next round of investors.
Do the math in “post money” valuation: the market value given to a start-up after the next round of financing is completed. How much dilution will occur: what % will you have after the next deal is done, the SAFE notes convert.
Accelerators take share first
The SAFE note was created by Y Combinator, an Accelerator, who takes their equity first, and then issues a SAFE note for their batches of companies.
Unsophisticated founders and funders may not realize this and may only see the math results upon the next round of funding.
Trends in SAFE Notes
Global SAFE Note spread
The SAFE note has been copied and pasted and used throughout startup accelerators around the world – so make sure you do the math and understand the terms post money on the next deal before you sign.
Compare the YC SAFE note to a note in your local accelerator, particularly if you are not in the Bay Area. We’ve seen SAFEs spread to SE Asia, Europe. Africa, and South American startup ecosystems, but with deeply founder unfriendly terms. Make sure you’re not giving acquisition decision rights to your accelerator, and that the liquidation preferences are reasonable.
Local ecosystems standardize terms
As local ecosystems adopted and changed the SAFE notes, and saw frustration and backlash, the better Accelerators will work to standardize terms and spread the word about the downside to creating terms that are unfreindly to founders and confusing to investors.
Before You Consider SAFE Notes
- Do you understand post-money valuation if your SAFE notes do successfully convert to equity at a later round of funding?
- Are you aware that you will be expected to raise additional rounds of Angel, Seed, and Venture capital and that not many companies achieve this goal?
- If you are signing an agreement with an accelerator, do you understand their ownership stake and decision rights going forward?
Exploring SAFE Notes
- Ask fellow founders if SAFE Notes, Convertible Notes, or equity is more prevalent in your startup ecosystem
- Ensure you have a lawyer that is familiar with SAFE Notes and has a predictable pricing structure to support you through your early-stage fundraising.
Discover Alternative Capital
Compare SAFE Notes to Convertible Notes and Other Types of Capital. These capital types each represent one way to grow your company, and you can choose other capital types as an alternative or pair and combine at different stages of your business. Consider these alternative capital sources or explore our Capital Library.
