SAFE notes are a form of a convertible security. They are used as a legally binding promise that, at a later date, an investor will be given the opportunity to buy shares at an agreed price.
SAFE notes were developed in 2013 by the Silicon Valley accelerator, Y Combinator. As such, they are a relatively new option for investors and startup founders. However, they have become increasingly popular as a simple way to structure an investment for equity deal, especially during seed rounds.
To fully understand what they are, why they are used, and how to benefit from them, let’s now take a deep dive into answering exactly what a SAFE note is.
Understanding Why SAFE Notes Were Developed
Let’s say that you are a startup founder and you are looking for investment at the very beginning of your journey. This type of investment is referred to as a “seed” or “angel investor” round. It’s used to raise enough capital so that a business can do the groundwork necessary to secure larger amounts of investment in subsequent investment rounds – Series A, B, C, funding rounds, etc.
Traditionally, seed rounds are opportunities for individuals with high incomes (angel investors) to attach themselves to a company before it is properly established. This is to both help entrepreneurs and take a chance on an idea that it might become hugely profitable in the future.
Angel investors don’t tend to work with large, established companies. They leave that for bigger investors. As Catherine Clifford of CNBC puts it: “Angel investors typically seek out early-stage startups that aren’t big enough for the venture-capital firms”
In return for this investment, angel investors require something of monetary value. Usually, this is either equity or the promise of equity in the future.
One way to do this is through a convertible note. This is legal proof that a company not only owes an investor an agreed amount of equity but that the angel investor can convert this note into that equity when they choose after the agreement has been fulfilled.
The problem with convertible notes is that they are debt, and so this can have several negative consequences, including:
- It can put subsequent investors off from investing because they know someone else already has a claim to a sizable portion of the business. Also investors prefer straight equity.
- Investors can also be put off because these convertible notes are registered as debt, and a company with few or no debts is usually a more attractive investment opportunity than one with debts.
- Convertible notes are complex. Investors can attach stipulations to a convertible note that might seem insignificant at the time, but that can have a huge impact on a startup’s founders down the road.
However, convertible notes are, in my mind, one of the fastest and cheapest ways to fundraise. While equity rounds can be north of $20,000, convertible notes should not cost you more than $7,000.
One thing to keep a very close eye on is the maturity date. This is the date by which you agree to repay unless you have not done a qualified round of financing in which the convertible notes are converted into equity.
For this reason, make sure that the maturity date is a date that you feel confident about. You need to be convinced that you will be able to raise a qualified round of financing on or before that date in order to convert the notes into equity and avoid being in default. The last thing you want to happen is to be in default and to have to shut down your business because investors are demanding their money back.
Below is a good example of how convertible notes play out in real life.
The Benefits of SAFE Notes
Y Combinator developed SAFE notes in response to difficulties arising from convertible note agreements. Convertible notes were the predecessors to SAFE notes and, although they are still used, SAFE notes have a number of advantages.
To reiterate: The key distinction between both is that a convertible note is a form of debt. A safe note is not debt and is a form of a non-debt convertible security. This means that it can be “converted” into something of value at a later date.
SAFE Notes provide a number of benefits, including:
1) Important Agreements
While convertible notes have their negatives, they are still useful. Thankfully, SAFE notes include many of the useful parts of a convertible note. These include stipulations about any future bankruptcy event, company dissolution, early exits by both founders and investors, change of control, and any attached valuation caps.
2) Keeping it Simple
The reason for SAFE notes in the first place is that they are far simpler than convertible notes. Unlike a convertible note where interest payments must be made to the noteholder, SAFE notes do not require this. There is also no agreed end date to the SAFE note. It is a clearly stated agreement that doesn’t require a lawyer to understand, usually under 5 pages long.
3) Similar Accounting
There are no tricky tax consequences when using a SAFE note. Similar to any other convertible security, it is included in the capitalization table for the company’s accounts.
Negotiating with investors can be daunting for new entrepreneurs. This is especially true when a large number of stipulations are attached to any agreement. Because of the simplicity of a SAFE note, there are fewer points to negotiate over, keeping everything clear and easy to discuss.
5) Equity Conversion Available
Investors still have the ability to convert their investment into equity at a later date. It’s just not set in stone the way a convertible note is. Usually, the time for doing that will be agreed between the investor and the startup founders during subsequent investment rounds as more investors become involved.
6) Flexibility for Founders
In some cases, other types of convertible security become difficult for startup founders. They agree on terms that put them into difficulty later on. The key advantage of a SAFE note is that it provides founders with control and flexibility about any financial or equity-based payouts.
7) Investors Get More
Although the control is more on the founder’s side of things, SAFE notes offer investors benefits as well. The main one is that when SAFE notes are finally converted, they can pay in preferred stock or at a larger amount than might have happened with a convertible note.
The Negatives of Using SAFE Notes
Although SAFE notes provide many advantages, here are a few negative aspects associated with them to keep you fully informed:
For investors, it’s possible that they may never be converted into equity. This can leave investors with very little for their initial support. It all depends on how the business progresses.
One thing that convertible notes provide over SAFE notes is the continual interest. As SAFE notes aren’t a loan, there are no interest payments from the company. For this reason, investors can lose out on the interest and make less in the long run (unless the company is a runaway success before converting).
Common shares provide investors with dividends as the company increases its performance. However, this may not be the case with a SAFE note. Most SAFE noteholders will not receive dividends. Their real reward should be equity.
4) Unknown Consequences
Because SAFE notes are relatively new, the long term consequences of using them have not fully been explored, yet. There may be unforeseen circumstances that arise later on, negatively impacting investors, founders of both.
One quirk of SAFE notes is that a business must be incorporated in order to use them during negotiations. Some companies choose a different structure such as a limited liability company. This means that to issue SAFE notes, a company needs to restructure and become incorporated, which may require fees and legal advice.
Remember that storytelling plays a key role in fundraising and you will need capital to scale things up. This is being able to capture the essence of the business in 15 to 20 slides. For a winning deck, take a look at the template created by Silicon Valley legend, Peter Thiel (see it here) that I recently covered. Thiel was the first angel investor in Facebook with a $500K check that turned into more than $1 billion in cash.
Remember to unlock the pitch deck template that is being used by founders around the world to raise millions below.
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