Verbal promises are hard to prove, but notes are like a legal pinky promise.
SAFE notes are also kind of like a sticky-note IOU. Although you can’t stick a SAFE note to someone’s forehead, you can still use it to remind yourself or others of debt owed from securities.
There are several kinds of legal payable and non-legal notes. Why should or shouldn’t your business choose the SAFE route?
What is a safe note?
What are SAFE notes?
A Simple Agreement for Future Equity (SAFE) note is a simpler alternative to convertible notes. SAFE notes allow you to convert your investments into equity at a later date.
They address several problems found in convertible notes, but at the same time, they come with their own issues.
In 2013, Y Combinator, a Silicon Valley accelerator, created the SAFE note for the purpose of drafting a 5-10 page document that outlined each investment.
The SAFE note agreement anticipates that the investment amount is unsecured and will be drawn down in a lump sum.
These notes don’t have a maturity date or interest rates and have little negotiation room. Since it isn’t considered a loan, the investment amount remains outstanding until it’s converted into equity, or it’s repaid or converted during a liquidity event.
There are many reasons why you would use a SAFE note:
- Investors who want to set up a prime negotiating opportunity will invest in SAFE notes. With a high valuation cap, the investor could receive five to 10 times their invested amount.
- Founders will want to sell SAFE notes instead of stocks to avoid setting a value for their company. Startups typically have no value to investors (except angels) early on.
- Both parties benefit from failure or success in most cases. If the company fails, money left in the company goes to the investors; founders take from their company’s pocket.
- Both parties may prefer the simplified process of using SAFE notes that reduces the time and costs associated with financing. This leaves more money in the startup’s pockets.
Only the valuation cap, discount and financing threshold can be customized in a SAFE note. To maintain its simplicity, you can’t negotiate other aspects of the document at any time.
General SAFE note terms and jargon
There are a lot of terms used explicitly for SAFE notes that aren’t typically used elsewhere. This section explains what they mean for the layman, so you can better understand and use SAFE notes.
1. Validation Cap
A predetermined floor that sets the highest permissible value for the company. This is used instead of the actual value of the company when converting the SAFE notes into shares.
Provides the investor with a direct discount on the price per share that the notes will convert at, as compared to future equity investors. Investors can cash out when a conversion event occurs.
3. Pro-rata rights
If an agreement is “pro-rata,” it means investors can invest additional funds to maintain their ownership percentage during equity financing after the initial funding round when SAFEs convert into equity. The investor pays the new price of the round, not the initial cost.
4. Equity financing (also considered a converting event)
A growing company will do multiple rounds of equity financing to actively scale. If equity financing occurs, it raises the price of your SAFE notes if you use your pro-rata rights.
5. Converting events
As stated, a SAFE note can only be converted back into cash unless it’s turned into equity or repaid during an event. You’ll typically see the following event clauses in a SAFE agreement:
- Dissolution event: A dissolution event describes the voluntary or involuntary termination of the company.
- Liquidity event: A liquidity event may occur if the company’s founders feel their equity has little to no market value to trade on. It’s an exit strategy that allows founders and investors to cash out before it’s too late.
- Insolvency event: An insolvency event occurs when a person can no longer meet their financial obligations to lenders as debts become due. In this situation, a business may restructure its debts or file for bankruptcy.
Safe note types
There are four types of SAFE notes:
- Cap, no discount: Has only a valuation cap.
- Discount, no cap: Has no cap and contains a discount when the note converts.
- Cap and discount: Has both a valuation cap and a discount.
- MFN, no cap, no discount: Has no cap, no discount, but does contain the most favored nation principle. When the SAFE note converts to equity, the funds mostly stay within the company. MFN typically repels seed investors.
Although SAFE notes are much simpler to use and understand, there is a bit of a learning curve associated with the agreement. Despite their initial complexity, they have their benefits.
Benefits of using SAFE notes
When a founder is looking for a seed investment for their startup, a SAFE note agreement can offer several benefits to the companies that use them. Since the SAFE note is still considered a new document, you may need to explain why your investors also benefit from this agreement.
The benefits associated with SAFE notes include:
- Early exits: SAFE notes offer companies multiple ways to cash in on their equity.
- Accounting: SAFE notes are placed in a company’s capitalization table.
- Simplicity: SAFE notes are straightforward, small, and easy to understand.
- Flexibility: SAFE notes give startups more freedom due to the lack of maturity date.
- Equity: SAFE notes allow investors to convert their investments into equity.
- Little negotiation: SAFE notes are typically only negotiated based on cap.
- Preferred stock: SAFE notes can offer high-value preferred stock to investors.
The preferred stock allows investors to take advantage of dividends, which gives them priority during a conversion event. In fact, multiple equity rounds can offer even more benefits to potential investors.
How to use uncapped and capped SAFE notes
SAFE notes either come with a valuation cap or no cap. A “capped” investment round places a ceiling on the valuation once the notes are converted into equity, which gives investors an idea of how much of the company they’ll own. It’s easy to attract investors with a capped SAFE note.
Uncapped SAFE notes are riskier for investors but more favorable to the entrepreneur. The investor isn’t offered a guarantee of how much they’ll own. Let’s look at why that is:
Say an investor invests $200,000 in a company with a cap of $2 million. As long as the company’s value exceeds the investment amount, the investor will own 10% of the company until the subsequent financing round. At that point, they should invest more if the cap increases.
Now, say that investor invested $200,000 with an uncapped SAFE note agreement. Their share of the company will continue to diminish as the company grows. If that same company from the last example is valued at $20 million, the investor only owns 1%.
If you want to use both note examples properly, keep the following things in mind.
Uncapped SAFE notes:
- Founders shouldn’t issue these notes if they don’t understand the value of their company, especially in the case of MFN, no cap, no discount notes.
- Uncapped SAFE notes have a lower opt-in percentage than capped.
- It’s difficult to see a profit for both parties with uncapped SAFE notes.
- The discount, no cap note offers a better value for investors, as they have some idea of what they’ll earn back in equity.
It’s in your best interest to avoid uncapped SAFE notes. The valuation cap limits the risk of investing early but still gives the flexibility of the note. Seed investors should only use capped notes.
Capped SAFE notes:
- Make your first cap something low but reasonable, like $1-$3 million.
- Don’t do multiple investment rounds with different limits early; it’s risky.
- Avoid down rounds (financing rounds that decrease the price of their stocks) that can happen with discount and capped notes by doing an equity deal around $5-$7 million.
- Capped notes should come with a discount, as they offer more for investors.
- When doing a second or third round of investments, consider using a discount, no cap SAFE note. At this stage, investors won’t be scared away by the no cap.
- Use priced rounds in the second or third round to sell your equity in exchange for investments. This type of equity financing structure can build you a bigger safety net.
- While raising common stock is beneficial, it won’t trigger a protective conversion event. For extra cash, consider doing a “family round” to avoid the conversion event.
- Set up your notes with a minimum percentage of the equities cap, not the total value.
Although using a capped SAFE note is more advantageous than uncapped notes for both parties, there are a few risks and drawbacks that come with using all types of SAFE notes.
Risks and drawbacks of using SAFE notes
The SAFE notes’ biggest positive is their simplicity, but that can be terrifying for investors.
That small amount of wiggle room leads to a significant problem: different valuation caps for separate investors. Many founders will set up different agreements with different caps for investors they want to attract, but that reduces your previous investor’s investment.
You can easily avoid this problem by issuing only one cap per round, but SAFE notes are still risky even when accounting for this tiny snag. Like any legal document, SAFE notes aren’t perfect.
The risks associated with SAFE notes include:
- Risky investment: SAFE notes aren’t a debt instrument and may not turn into equity.
- Requires incorporation: SAFE notes are only offered to incorporated companies.
- Unfamiliarity: SAFE notes use specific legal speech that isn’t commonly known.
- Low returns: SAFE notes won’t offer returns if you hold onto them for over a year.
- Dilution: SAFE notes may dilute the investors’ ownership of the company.
- No options: SAFE notes come in four types, but only the cap and discount option is viable.
- Triggers fair valuation: SAFE notes could start a fair valuation (409a), which requires a company to pay for a lawyer or professional accounting service. Both are pricey.
Still want to use a SAFE note? There are a few ways you can limit or solve SAFE note problems.
How to prevent SAFE note problems
There are problems with SAFE notes, but there are many ways to prevent them. Unfortunately, the answer to solving your SAFE note problems narrows down to not using them at all.
Pre-money vs. post-money valuation
Several investors and entrepreneurs don’t understand what pre vs. post-money valuation is and how this knowledge can solve several note problems.
Pre-money valuation is the value of a company before external funding, or the latest round of funding takes place. This helps startups determine what they may be worth before investing.
Post-money valuation is the value of a company after external funding, or after the latest round of funding, takes place. Post-money valuation includes all outside financing or capital injection.
When a business issues additional SAFE notes, the equity moves further from the original valuation cap, leading to a large gap between the pre-money and post-money valuation.
Founders should understand that dilution already happened when they issued the SAFE notes. If the company’s value drops significantly, it’s likely that financial structure changes or the price of the notes are to blame, but this problem is usually caused by the decision to issue notes.
To avoid this problem, companies should offer investors their post-money valuation amount because investors will have a better idea of what portion they own of the business.
SAFE notes vs. convertible notes
SAFE notes are similar to convertible notes. After all, SAFE notes were created by using convertible notes as a starting point to make the investing process less complicated.
However, convertible notes may provide more value in some circumstances.
Before we get to that, let’s take a look at how SAFE notes and convertible notes look the same on the surface.
- Both notes use discounts and validation caps as a basis of the document.
- Both notes could be issued with no cap if you learn how to negotiate a contract.
- Both notes have similar converting events that offer an early payout.
- Both notes can contain insolvency events, but you need to write this into a SAFE note.
- Both notes provide even more benefits to investors who duck out early with a discount note.
- Both notes become equity in subsequent priced rounds.
- Both notes feature savings, value maxims, and MFN clauses.
Despite their similarities, convertible notes have more benefits than SAFE notes in most cases.
The pros of using convertible notes instead of a SAFE note:
- Convertible notes become simple to make, send, and initiate with a discount, valuation cap, and a convertible note agreement template, like the legally binding one available for free from PandaDoc, because they’re generally known.
- Convertible notes have a maturity date, interest rate and can be used by a C-corp.
- Convertible notes transform only when a qualifying transaction takes place.
- Convertible notes allow companies to receive capital without a complicated equity round.
- Convertible notes sit at the top of the cap table but are flexible. This means investors can’t foreclose on a company’s assets and can’t take back unpaid property.
- Convertible notes allow investors to change the note into equity if the startup is acquired.
- Convertible notes are attractive to investors because of the maturity date and interest rate. Their investment continues to accrue, raising its value over time.
Learning how to send a convertible note to an investor will set you up for success. Why? Because convertible notes are considered fairer than SAFE notes by most investors.
The KISS: When to use one instead of a SAFE note
The “Keep It Simple Security” (KISS) merges the simplistic SAFE with the in-depth convertible note. Since KISSes take an investor-friendly approach with their protective mechanisms, they’re more likely to attract capital. Plus, you won’t need to spend hours negotiating terms.
The pros of using KISS instead of a SAFE note:
- KISSes have downside protections not found in SAFE notes.
- KISSes, unlike SAFE notes, have an interest rate and end date.
- KISSes are more customizable than SAFE notes.
- KISSes give investors rights that could prevent a company’s financial issues.
However, there are flaws with using a KISS:
- KISSes are more complex than SAFE notes and require some degree of discussion.
- KISSes usually need to be drafted by an attorney, which requires time and money.
- KISSes are even less popular than SAFE notes.
- KISSes are too similar to convertible notes to be considered “unique.”
While KISSes aren’t necessarily better or worse than SAFE notes or convertible notes, it provides investors and founders with another option for receiving seed money from investors.
Get started writing SAFE notes with PandaDoc
The SAFE note is one of the newest business documents around, and it helps to know what they are. Despite their use in business, especially when it comes to investment proposals, SAFE notes need a bit of tweaking and negotiating to be beneficial for both parties.
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