A SAFE (Simple Agreement for Future Equity) note is an agreement between an investor and a startup to exchange capital for equity at a future date. It is becoming a more favored financing method for startups in their early stages.
SAFE notes differ from notes in that they do not come with an interest rate or maturity date. When an investor offers capital to a startup through a SAFE note, they gain the option to acquire equity when the company conducts a priced equity financing round at a date.
The key features of SAFE notes include:
The 'post-money safe' is a variation of the SAFE note that was first introduced by Y Combinator in 2018 emphasizing its nature and modernized format. This advancement, in early-stage agreements and funding tools for businesses, showcases the changing terrain of startup funding.
So in summary, SAFE notes provide capital to startups today in exchange for the right to get equity at a future date when the startup sets a valuation. It avoids setting a valuation prematurely.
SAFE notes offer several key benefits that make them an attractive financing option for many early-stage startups:
Simplicity
One of the biggest advantages of SAFE notes is their simplicity compared to other financing instruments. SAFE notes don’t require determining a valuation or going through complex negotiations over equity stakes. The agreements are relatively straightforward and fast to put together. This simplicity enables startups to raise funds quickly from investors without excessive legal costs.
Faster Fundraising
For early-stage startups, speed is critical when trying to raise capital before running out of runway. The streamlined process of finalizing SAFE note terms versus hammering out a priced equity round enables startups to close financing much faster. Rather than getting bogged down in valuation discussions, startups can secure funding rapidly with SAFE notes.
Alignment of Interests
SAFE notes help align the interests between founders and investors. With SAFE notes, investors do not get equity immediately but will get equity at the same terms as future investors during the next equity round. This encourages investors to contribute value and support the startup's growth aiming for a round where their SAFE notes can convert advantageously. Investors typically consider the potential of startups, for long-term gains. Moreover, early investors benefit from SAFE notes as they enable them to convert their investment into equity under conditions in equity rounds, ensuring they can retain or potentially grow their ownership share in the startup.
While SAFE notes provide an adaptable financing option for early-stage startups, they do come with downsides to take into account. Two primary drawbacks include;
Lack of governance rights - Unlike equity investors, holders of SAFE notes do not have voting rights or board seats. This means they lack control or influence over the company's operations until conversion. The founders maintain full discretion until the next equity financing round.
Valuation uncertainty - With a SAFE note, valuation is postponed until an equity round. This delay could result in valuation outcomes for founders if the company's value does not rise as anticipated. The uncertainty surrounding valuation and postponing it to a stage can complicate cap tables. Introduce risks for both startups and investors who must navigate through these complexities without a clear valuation cap, like that provided by convertible notes.
The deferred valuation and lack of investor rights are tradeoffs that come with the flexibility of SAFE notes. Some investors may prefer the defined terms associated with notes or priced equity rounds. In the case of early-stage funding when a company's worth is uncertain, SAFE notes offer a method to ensure both founders and investors are on the same page for the upcoming fundraising round.
A crucial element in a SAFE note agreement is the valuation cap. This cap determines the value the company can have in an equity round before the SAFE note transforms.
For instance, if a startup establishes a $5 million valuation cap on a SAFE note and later conducts an equity round at a $10 million valuation, the SAFE note would convert as if it were based on $5 million rather than $10 million. This enables SAFE note investors to receive ownership in the company compared to if conversion was based on the $10 million valuation.
The valuation cap holds significance as it safeguards SAFE note investors from losses. If in a round, the company raises funds at a high value, the valuation cap restricts how much the SAFE converts.
Some key considerations around valuation caps:
Setting the right valuation cap requires balancing the interests of both founders and SAFE note investors. Founders do not want to set the cap too low and dilute their equity heavily in the future. Meanwhile, investors want a lower cap to maximize their potential equity ownership if the valuation increases significantly.
One key term in a SAFE note agreement is the discount rate. The discount rate determines the reduced price at which the SAFE note converts to equity in a future priced round. This allows SAFE note holders to buy shares at a discounted rate compared to investors in that round.
A higher discount rate is more favorable for SAFE note investors as it lowers the effective price they pay for the startup's shares. However, startup founders generally prefer a lower discount rate. This minimizes dilution of the founders' ownership when the SAFE converts.
The discount also incentivizes SAFE investors to help the startup raise its next round. By doing so, they can convert their investment to equity at a reduced rate. The discount rate often ranges from 15% to 25% in most SAFE note deals.
When discussing the discount rate, both parties should take into account factors such as the startup's progress since issuing the SAFE, its valuation, and the founders desired ownership percentage upon conversion. Ensuring alignment of interests between founders and investors can result in a discount rate.
Overall, the discount rate directly impacts the potential return for SAFE note holders. It gives them a preferential rate compared to new investors when the startup raises its next round of financing.
Upon a startup successfully raising an equity financing round that meets the requirements specified in the SAFE agreement the SAFE notes automatically convert into equity shares. Noteholders do not need to initiate any action for this conversion. This conversion typically occurs during a subsequent funding round, which influences how SAFE note holders transition their investment into equity.
The conversion process follows the terms outlined in the SAFE note. Determines how many shares are converted based on factors, like valuation cap, discount rate, and valuation established in the funding round.
Upon conversion, the SAFE note principal converts into equity shares based on the valuation cap or the discounted price. Any unpaid interest also converts into equity.
Conversion has a direct impact on the startup’s cap table. The SAFE note holders who invested earlier now appear on the cap table with an equity stake calculated based on the conversion price.
Existing shareholders may see their stakes diluted with the addition of converted SAFE note holders. Managing this dilution and aligning incentives between early SAFE investors and founders is an important consideration when structuring SAFE deals.
Properly tracking SAFE note conversions is critical for maintaining an accurate cap table as more investors join in subsequent rounds. Companies should have clear conversion procedures in place to seamlessly convert SAFE notes into equity when conversion events occur.
SAFE notes are listed as liabilities on a company's balance sheet because they signify a commitment to issue shares. Accounting regulations mandate that SAFE notes be categorized as liabilities rather than equity due to this obligation.
According to ASC 815, SAFE notes are viewed as "freestanding financial instruments" since they can be detached and exercised independently. Typically the initial carrying value of a SAFE note liability equals the investment made by the SAFE investor.
Changes in the fair value of the SAFE note liability are recognized as gains or losses on the income statement. Factors that impact the fair value include the company's financial performance and changes in fair market value.
As a company nears an equity financing event that would prompt the conversion of SAFE notes, the instruments start to resemble preferred stock more closely. Consequently, the classification of the SAFE note liability shifts to mezzanine equity on the balance sheet.
When converted into equity, the liability associated with SAFE notes is removed from accounting records, and any preferred shares issued are valued at their market value. Any difference between the carrying value of the SAFE note liability and the fair market value of the equity issued is reported as either a gain or loss upon conversion.
Proper handling and valuation of SAFE notes call for expertise to ensure adherence to accounting standards. Companies should collaborate closely with auditors and advisors when issuing SAFE notes to grasp their implications.
A critical tax consideration regarding SAFE notes revolves around whether gains, from conversion will be treated as income or capital gains.
When a SAFE note converts, the profit, from the increase in the value of the received shares compared to the investment is subject to taxation. This profit is usually categorized as a capital gain, which incurs a tax rate than income.
However, the IRS could potentially categorize the gains as ordinary income if the SAFE note lacks economic risk or substantial investment intent. This is more likely if the conversion happens shortly after the initial investment.
To secure the capital gains tax treatment, investors of SAFE notes can opt for an 83(b) election by submitting IRS Form 83(b) within 30 days of obtaining the shares. This choice allows for taxation at the capital gains rate.
Opting for an 83(b) election involves some risk since investors are required to pay capital gains tax even if the share value decreases. Investors should seek advice from a tax professional before deciding on making an 83(b) election regarding SAFE note conversions.
In general, SAFE notes investors must understand and consider any variations in tax implications compared to equity investments. Effective tax planning plays a role in reducing income tax responsibilities.
Some notable startups have used SAFE notes to raise early-stage capital before pursuing larger VC rounds. Here are a few examples of startups that successfully leveraged SAFE notes:
These examples illustrate how SAFE notes can provide startups with growth capital in the early days while enabling founders to delay dilution and set favorable terms in future priced equity rounds.
When issuing SAFE notes, startups need to follow some best practices to ensure a smooth process and favorable terms. Here are some tips:
Use a SAFE Note Template
Start-ups should use a standardized template rather than creating a SAFE note completely from scratch. This saves legal fees and ensures the SAFE note includes key terms like the valuation cap, discount rate, and conversion terms. Popular templates are available from Y Combinator and SeedInvest.
Build Investor Relationships
Don't just send a generic SAFE note to potential investors. Take the time to build relationships first and tailor the SAFE note terms to each investor's preferences. This increases the likelihood they will invest. Provide thorough information on your startup's progress and how you'll use the funds.
Careful Documentation is Crucial
Meticulously document each SAFE note investment and keep organized records. Log key details like investor names, investment amounts, and SAFE note terms. When the conversion trigger occurs, you'll need this documentation to issue shares properly. Use capitalization table software to track SAFE noteholders.
Communicate with Investors
Keep SAFE note investors updated on your startup's progress at least quarterly. They are stakeholders too. When raising a priced equity round to trigger conversion, alert SAFE note holders of the key terms. Avoid surprises - transparency builds trust.
Following best practices with templates, investor relations, and documentation helps startups smoothly issue SAFE notes and sets up future priced rounds for success.
