Key Takeaways

• A Simple Agreement for Future Equity is a contract between an investor and a startup that lets the investor convert their investment to equity at a future time.
• These agreements typically work like a convertible note. However, since they aren’t debt instruments, SAFE notes don’t have provisions for interest and maturity dates.
• SAFE notes typically include valuation caps and discount rate clauses to incentivize investments.
• The pros of issuing SAFE notes include quicker access to capital, equity preservation, and their appeal to risk-taking investors. Cons include difficulty getting new investors onboard without a lead investor and the potential for excessive dilution.

What Is a SAFE Note?

A Simple Agreement for Future Equity (SAFE) is an investment contract that lets an investor convert their investment into equity at a future funding round or liquidity event. Early-stage startups typically use them when attracting investors and raising money for their operations. 

SAFEs trace their origins to 2013 when the startup incubator Y Combinator developed them to make early-stage funding quicker and easier. They’re generally believed to have been created as an alternative to the convertible note, a financial instrument that also converts into equity.

How SAFE Notes Work

SAFE notes are generally designed to simplify and expedite the investment process for investors and startups. They borrow the core idea behind convertible notes (i.e., the ability to convert to equity in the future) while discarding their excess elements. 

For example, unlike convertible notes, SAFE Notes aren’t debt instruments. Thus, they do not contain provisions for interest rates or maturity dates (i.e., the day the invested money must be returned). 

The latter point means that an investor may never get their money back if the agreed-upon trigger for the SAFE note’s conversion into equity never materializes.

Requirements for Issuing a SAFE

Founders who are considering issuing SAFE notes may need to form a C-Corporation before doing so.

Some Investors typically view Limited Liability Companies (LLCs) as being riskier than C-Corps, and the SAFE fundraising process for LLCs can be complicated. 

C-Corps may also help with investor confidence since they show that your company has a clear ownership structure complete with a cap table, and you pay taxes.

SAFE notes can be issued through Regulation CF crowdfunding or Regulation D private placements. Each option has different legal requirements, investor qualifications, and liquidity restrictions. Be sure to understand which structure applies before investing.

Important SAFE Note Clauses to Know

From an investor’s point of view, a SAFE investment can seem risky. Thus, startup founders typically include the following clauses to reward investors who express a willingness to take the risk:

Valuation Cap

The valuation cap clause sets a maximum valuation (e.g., $3,000,000) that the investor’s investment will convert into equity. It protects the investor’s potential stake in the startup from excessive dilution during future funding rounds.

Including a valuation cap clause in a SAFE note ensures that an investor’s investment gets priced at the lower of it. For example, suppose a SAFE has a $3 million valuation cap and the startup is valued at $10 million at a subsequent funding round. In that case, the investor’s SAFE will convert to equity using the $3 million valuation cap. 

Discount Rate

The discount rate clause ensures that an investor’s capital injection converts to equity at a discounted rate at a future funding round. Early-stage investors who have a discount rate clause in their SAFE notes may receive shares at a lower price than new investors, depending on the terms.

Startups include it in SAFE notes to incentivize early-stage investments and compensate investors for taking a chance on a risky venture.

Types of SAFE Notes

Not all SAFEs contain a discount rate or valuation cap clause. The inclusion of either or both depends on what makes the most sense to the parties involved. Thus, there are four types of SAFE notes an investor and startup can contract with:

1. Cap, No Discount: This SAFE note includes a valuation cap clause but no discount rate for the price per share.
2. Discount, No Cap: While SAFEs like this include a discount rate clause, they exclude the valuation cap.
3. Cap and Discount: These SAFE notes include both the valuation cap and discount rate clauses.
4. Most-Favored Nation: This SAFE note excludes both the valuation cap and discount rate clauses. It typically includes the Most-favored Nation clause, which entitles the investor to the same terms as new investors (who also don’t have valuation caps or discount rates).

All four types have their pros and cons for investors and startups. It’s best to seek expert advice (legal and financial) before pushing ahead on the SAFE note variant you’re asked to agree to.

Fundraising With SAFEs  

Here are few potential benefits and risks these instruments provide and pose to investors and founders:

Pros

• Quicker and Cheaper Fundraising: SAFEs don’t have as many terms that require hashing out by the parties involved. Thus, they offer a quick way for founders to get funding and investors to park their money in early-stage ventures. Additionally, since a SAFE note isn’t a pure convertible instrument, it doesn’t carry interest or have a set repayment date. These qualities make it a quicker and cheaper fundraising method for entrepreneurs.
• Equity Retention: A SAFE holder doesn’t get equity in the startup until a conversion event occurs. This means that founders can make decisions that grow their ventures without being beholden to company outsiders. The flexibility also lets founders retain ownership until they’re ready to issue preferred stock in exchange for funding.
• Appealing to Risk-Tolerant Investors: Investors who are comfortable with high risk may find certain SAFE terms, such as valuation caps and conversion discounts, to be attractive, but returns are not guaranteed and vary based on company performance.

Cons

• Difficulty Attracting Investors: Offering SAFE notes may put off risk-averse investors. Also, it may prove challenging to attract other investors without the backing of a lead investor (via a priced round).
• Excessive Dilution: Founders who aren’t careful about their valuation caps risk diluting the shares they own or shares meant for Series A investors.
• Potential risk: SAFE notes are highly speculative and illiquid. Investors should be aware that they do not guarantee a return on investment and, in some cases, may result in a total loss of invested funds if the company does not reach a conversion event or fails entirely. Investors should also consider the possibility of extended holding periods without liquidity options.

Conclusion

SAFE notes offer a potential funding mechanism for early-stage startups and an investment opportunity for individuals willing to accept the associated risks. While they may provide a streamlined and flexible alternative to traditional convertible notes, their structure presents unique considerations for both founders and investors.

Given the potential for dilution, illiquidity, and loss of investment, individuals considering SAFE notes should carefully assess their risk tolerance and seek professional guidance to ensure alignment with their financial goals.

Disclaimer:The information provided in this article is for informational purposes only and should not be considered financial, legal, or investment advice. SAFE notes are complex financial instruments that may not be suitable for all investors. Investing in early-stage companies carries a high risk of loss, including the potential for a total loss of capital. Investors should conduct their own due diligence and consult with qualified financial, tax, and legal professionals before making any investment decisions. The inclusion of any specific terms or examples does not constitute a recommendation or endorsement of any particular investment strategy or security.

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