A SAFE note is a financial instrument that allows investors to provide capital to startups in exchange for a promise of future equity, hence the term Simple Agreement for Future Equity.

Investors receive the right to convert their SAFEs to equity shares in the company after a triggering event, which is generally the next priced equity round. Until the priced round or liquidation event you retain full ownership of your business. Once the triggering event occurs, investors receive equity based on the SAFE note’s valuation cap or discount rate.

SAFE notes are a simple, easy and fast form of financing and have largely replaced convertible debt for funding angel, pre-seed and seed rounds. Because SAFE notes are easy to document and can be quickly executed, they have become an attractive option for raising early-stage capital.

Unlike convertible debt, SAFEs do not carry interest and have no maturity date. What they typically do have is a negotiated valuation cap that sets a limit on the price at which the notes convert to equity when the startup has another round of funding. This helps incentivize early-stage investors.

While most SAFE notes carry a valuation cap, some notes are structured to convert at a discount if the company is valued lower in a future capital raise.

Valuation Cap and Discount Rate

The valuation cap sets the maximum company valuation at which the note will convert into equity thus protecting the investor from excessive dilution in subsequent financing rounds. The cap allows the investor’s equity to be priced at the lower of the valuation cap, and the company valuation in the subsequent fundraising round.

The conversion discount allows the early-stage investment to convert into equity at a discount from the price paid by investors in a future financing round. This incentivizes early-stage investors and compensates them for taking on greater risk.

SAFEs can be appealing vehicles for early-stage investors who stand to gain from upsides in the company’s future valuation. There are several types, each with its own characteristics:

Cap-only: Straightforward and often preferred by investors who believe the company’s value will exceed the cap at the next funding round.
Discount-only: Less common and typically used when the company’s potential value is uncertain.
Cap-and-Discount: These include a valuation cap and a discount, offering investors the better of either option when converting.
MFN (Most Favored Nation): This has no cap or discount; it allows investors to adopt the terms of any better SAFE that may be issued before the triggering event.

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.

Because SAFE Notes are not debt, there is no interest rate or maturity date. Barring bankruptcy, SAFEs are typically converted into shares.

Advantages of SAFE Notes

• With an average agreement running just a few pages, SAFEs are less complicated and easier to understand than other financial instruments. They typically require less legal review and expense.
• SAFEs have relatively few, clearly outlined terms and conditions and can be tailored to a specific investor’s request.
• Because SAFE’s are not loans, there is no debt service or associated cash drain, and accounting considerations.
• Since the associated stock is not issued until the trigger event, equity dilution is also deferred.

Disadvantages of SAFE Notes

• Given uncertainties in company performance, market conditions and the competitive environment, valuation caps do not necessarily represent a floor in a future valuation.
• Issuing multiple SAFEs can result in considerable equity dilution if the company’s value at conversion significantly exceeds the caps, leading to less control and potential difficulty attracting Series A or other investors.
• Managing the cap table can get complicated if SAFEs are issued with different terms.

Investor Perspectives

Unlike traditional equity, SAFE notes often offer fewer protections, which might deter some types of investors. Also, the conversion terms of SAFE notes can lead to uncertainty and complications during acquisition or further capital raises.

While SAFE notes are generally founder-friendly, investors may negotiate certain rights to protect their investment. Make sure that you understand these rights and bake them into your agreement.

Savvy early-stage investors place a high value on pro rata rights, which allow them to maintain their ownership percentage by investing additional capital in future financing rounds. Having the right to keep investing in subsequent rounds helps minimize the early stage investor’s dilution.

While it’s common for larger SAFE investors to ask for pro rata rights, founders need to be cognizant that such rights can set precedents that crowd out investors in subsequent rounds. So, it becomes a balancing act.

When to Consider SAFE Notes

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, SAFEs might be preferred.

Early stage, when valuation is uncertain

SAFE notes are commonly used for seed-stage or early-stage fundraising, when the valuation of the startup is uncertain or difficult to determine. In the early stage, setting valuation can be challenging. SAFEs allow investors to defer the valuation discussion until a later funding round. This can be advantageous for both the startup and the investors.

Legal and Regulatory Considerations

Notwithstanding their simplicity, SAFE notes operate within a complex legal and regulatory environment.

• SAFEs are typically considered securities and must comply with applicable registration exemptions, such as Rule 506 of Regulation D.
• Ensure proper documentation, including relevant board resolutions and appropriate disclosures.
• Be aware of relevant state regulations that may affect how SAFEs can be used.

Think Ahead

• Pay careful attention to the valuation cap and discount rate, as these will significantly impact future dilution.
• Plan for Conversion by modeling SAFE note conversions in future equity rounds.
• Try to keep SAFE terms consistent if you are issuing them to multiple investors: This will simplify things when it comes time for conversion.
• Communicate with SAFE investors as you would with other stakeholders.
• Evaluate SAFEs in the context of your overall funding strategy, especially when considering future capital raises.

The choice between a SAFE and a convertible note ultimately depends on the specific circumstances and negotiation between the startup and the investors.

Wilchins Cosentino & Novins LLP provides advice and counsel to businesses including early stage businesses involved in securing funding. Contact our attorneys in our Business Law practice to discuss your goals and evaluate along with financial professionals whether SAFE notes are a good funding alternative.

Contact us.

Stephen N. Wilchins is a Founding Partner at Wilchins Cosentino & Novins LLP where he leads the Private Client Servies practice and provides counsel to business owners and leaders on business law matters ranging from formation to funding to exit strategies. Learn more about Steve.

This article is not legal advice and should not be taken as such or relied upon as legal advice.