Guide to SAFE notes: How they work and why startups use them

What is a SAFE note?

A SAFE (Simple Agreement for Future Equity) note is an investment tool startups use to raise capital from investors, where the investor provides funding to the startup in exchange for that investment converting into equity at a discount at a later date in a future-priced round of investment (e.g., Series A). 

The concept was first introduced by Y Combinator in 2013. 

A SAFE note is not a debt instrument like a convertible note. Why? The investor is not lending money but purchasing the right to future equity. A SAFE note does not have an interest or maturity due date when the investment must be paid back.

Advantages of SAFEs

SAFE agreements offer several advantages that appeal to early investors and early-stage startups raising seed funding.

Let’s dive into them. 

• Simplicity. One major benefit is their simplicity. SAFE notes are short, simple legal documents (compared to priced equity rounds) with fewer terms to negotiate (such as liquidation preference or protective provisions).

In other words, SAFEs can be executed quickly with minimal legal costs because they are straightforward, providing startups with a fast and affordable way to raise capital.

• Delay a formal valuation. Another key advantage is that SAFE notes delay setting a formal valuation for the startup until a future-priced equity round (when the SAFE converts to shares). 

This allows startups to raise funding without prematurely locking in a low valuation before their company has matured. 

• Incentives for investors. It doesn’t stop there, though. SAFE notes also provide incentives for investors through valuation caps that set a maximum valuation for conversion and discount rates that give investors a reduced price per share compared to future investors.

Now, from an accounting perspective, SAFE notes are typically treated as equity rather than debt, avoiding interest payment obligations.

Some SAFE note holders can also negotiate for pro-rata rights to maintain their ownership percentage in future rounds.

Simplicity, delaying valuation setting, and investor incentives make SAFE notes an attractive, founder-friendly option for early seed funding rounds.

Disadvantages and risks of using SAFE notes

SAFE notes have potential disadvantages. 

• Dilution of equity stake. One of the major risks associated with SAFE notes is the potential for significant dilution of the founders' equity stake. 

Because SAFE notes convert to equity during a future priced round, the more SAFE notes a startup issues, the greater the dilution will be when they convert. This can result in founders owning a much smaller percentage of their company than initially anticipated.

• Complex calculation. Additionally, multiple SAFE notes are issued with different valuation caps and discounts. In that case, the calculation of equity distribution can become extremely complex, leading to unforeseen dilution levels for entrepreneurs and earlier investors.

• You need to consider valuation caps. SAFEs are airtight. There is no confusion about how they would convert. However, you want to ensure that if a SAFE investor gets a valuation cap higher than the valuation of the next equity round, they do not effectively get any discount on their investment. That is when a founder would want to renegotiate or be unhappy.

• Fewer protection and rights for investors. Another disadvantage is that, unlike traditional priced equity rounds, SAFE notes typically offer fewer protective provisions and rights for investors, such as voting rights, information rights, or anti-dilution protections. This lack of formal investor protections may deter some sophisticated or institutional investors from participating in SAFE note rounds.

• Complex accounting. The accounting treatment of SAFE notes can be complex, too, and there may be tax implications for both the company and investors during the conversion process. That’s why consulting with professionals is advisable to better understand and plan for these potential implications.

The bottom line is that while SAFE notes offer simplicity and flexibility for early-stage fundraising, before utilizing this investment agreement method, founders must carefully consider the risks of potential dilution, uncertainty around conversion terms, lack of investor protections, and accounting and tax complexities.

Key vocabulary to understand in a SAFE note agreement

To grasp SAFE notes well, let’s review the key vocabulary you will often see in these agreements.

Valuation Cap

The valuation cap puts a maximum "price tag" on the company. The lower the valuation cap, the more shares the SAFE investor can get per dollar invested.

Discount Rate

The discount rate gives the SAFE note investor a discounted price per share compared to the price paid by new investors in the next equity round of financing. For example, a 20% discount means the SAFE investor gets shares at 80% of the new round's price.

Conversion Trigger

This refers to the specific event that will trigger the conversion of the SAFE note into equity shares. Typically, this is the next priced equity financing round above a certain threshold amount. We will review trigger events later in this guide.

Pro-Rata Rights  

Pro-rata rights allow SAFE investors to maintain their ownership percentage by having the right (but not the obligation) to participate in future equity financing rounds on a pro-rata basis. We will also review these later in the guide.

What are the four types of SAFE notes?

Valuation cap, no discount

This type of SAFE note has a valuation cap that sets the maximum valuation at which it can be converted to equity, but it does not have a discount rate.

Discount, no valuation cap

This discount rate gives the investor a discounted price per share when converting but no specified valuation cap.

Valuation cap and a discount

This gives the option of either a valuation cap or a discount rate, whichever results in a lower price per share.

No valuation cap and no discount (commonly called MFN for Most Favored Nation) 

This type does not specify a valuation cap or discount rate upfront. The terms would match the next priced equity round.

The valuation cap and discount rate are the two key economic terms that can be negotiated in a SAFE note. Having one, both, or neither impacts how the SAFE investment will convert to equity relative to the pricing of a future equity round.

Is a SAFE note considered a security?

Yes, a SAFE note is considered a security because it represents an investment contract that gives the investor the right to receive future equity in the company. 

The SEC regulates SAFE notes under the Securities Act of 1933 and the Securities Exchange Act of 1934, which define securities to include any "note, stock, or similar financial instrument."  

Once the equity financing round occurs, the shares issued from the conversion of the SAFE note are considered securities. These must comply with securities laws, requiring registration or a valid exemption. 

Can companies outside the U.S. use SAFE notes?

Yes. The fundamental principles of how SAFE notes function remain consistent across markets with an active venture capital scene.

However, companies using SAFE notes outside the U.S. need to be aware that, based on the specific country's laws and regulations, these may be treated differently from a legal, tax, and accounting perspective.

In Europe, SAFE notes go by different names: BSA Air in France, SLIP in Norway, WISE in Sweden, and SeedFast in the U.K. One key difference is that while SAFE notes in the U.S. typically do not have a maturity date, in Europe, they often include a maturity date of 2-4 years after signing. After that date, investors can convert based on a pre-negotiated fallback valuation. 

How does a SAFE note work?

Let’s break down how SAFE notes work in a step-by-step process.

1. The investor provides capital to the startup upfront via the SAFE note. This allows the startup to raise seed funding prematurely without setting a formal valuation. (Note that a SAFE note is not a debt instrument, as we stated before. So, there is no interest rate or maturity date. The investor is not lending money to be repaid.)

2. The SAFE note converts to equity (shares of preferred stock) when a specified "conversion event" occurs, typically the next priced equity financing round above a certain threshold amount. (Remember, SAFE notes often include a valuation cap or a discount rate, benefiting the investor.)

3. At conversion, the investment amount is divided by the capped valuation or the new round's pricing (whichever is more favorable to the investor) to determine the number of shares issued. (Some SAFE notes allow investors to maintain their ownership percentage in future rounds via pro-rata investment rights.)

In essence, SAFE notes allow startup founders to raise funding by promising future equity to investors without setting a formal valuation until the next priced round when the SAFE converts to shares based on negotiated terms (e.g., the valuation cap and/or discount).

Conversion events (also called trigger events or triggering events)

A conversion event forces the SAFE note to convert to equity. Also called “trigger events,” conversion events are priced equity rounds, exits like acquisitions, Initial Public Offerings (IPOs), and potentially a maturity date provision.

Let’s go over each type of SAFE note conversion event example. 

• Priced equity financing round: This is the most common conversion event. The SAFE note automatically converts to equity (typically preferred stock) when the startup raises its next priced round of equity financing, such as a Series A round. 

• Company sale or acquisition: If the startup is acquired or there is a change of control event like a merger, the SAFE note will convert into company shares before the sale or acquisition.

• IPOs: Going public through an IPO is considered a conversion event, causing the SAFE to convert into equity shares before the company lists publicly.

Investor rights

Investor rights are limited until the actual conversion event occurs. Generally, SAFE notes do not provide the full range of protective provisions and controls investors receive when directly purchasing equity, such as board representation, anti-dilution rights, or inspection rights. 

Prior to the SAFE converting into true equity ownership, investors have the following rights: pro-rata, information, dissolution, repurchase, and MFN rights.

Let’s review them. 

• Pro-rata rights: Pro-rata rights allow SAFE investors to maintain their ownership percentage by having the right (but not obligation) to participate in future equity financing rounds on a pro-rata basis. This prevents their ownership from being diluted by future investors.‍
• Information rights: Investors may also have information rights. Some SAFEs may be negotiated with a Side Letter that grants investors the right to receive certain information from the company, such as financial statements or updates on company performance, even before conversion.‍
• Dissolution rights: Investors also have rights on dissolution. SAFEs can specify what happens to the investment amount if the company dissolves before conversion, such as a return of capital or a right to proceeds upon dissolution.‍
• Repurchase rights: Certain SAFEs may allow the company to repurchase future equity rights from investors instead of converting them to shares based on pre-negotiated terms.‍
• MFN rights:  The MFN provision we previously mentioned allows SAFE holders to amend their agreement to match any more favorable terms granted to future SAFE investors in the same round.

So, while these rights are restricted pre-conversion, SAFE note agreements can include pro-rata, information, limited voting, dissolution, repurchase, and MFN rights.

How to calculate the conversion price of a SAFE note

Two main factors impact the SAFE conversion price: The valuation cap and the discount rate.

Valuation Cap. If the SAFE has a valuation cap, the conversion price is calculated as follows:

Valuation Cap / (Outstanding Shares + Outstanding Options + Option Pool Increase)

Discount Rate. If the SAFE has a discount rate instead of or in addition to a valuation cap, the conversion price is calculated as:

(1 - Discount Rate) * Preferred Price Per Share in the New Round

The SAFE conversion price is set as the lower of the valuation cap calculation or the discounted preferred price.

For example, if the valuation cap gives $1.50 per share, but the discounted new round price is $1.20, the SAFE would convert at $1.20 per share.

The number of shares issued to the SAFE holder is then calculated as:

SAFE Investment Amount / Conversion Price

So, in summary, the valuation cap and/or discount rate provisions benefit the SAFE investor by giving them a lower effective price per share when converting their investment to equity in the future priced round.

When should startup founders use SAFE note financing?

The simplicity, deferred valuation, and founder-friendly terms make SAFE notes an appealing option for early-stage startup founders looking to raise seed capital quickly before pursuing larger institutional round of funding.

Let’s go over some key scenarios where using a SAFE note could be advantageous for startup founders.

1. When the startup's valuation is uncertain or difficult to determine. 

SAFE notes allow startups to raise funding without having to set a formal valuation prematurely, before they have more traction and financial data. The valuation is deferred until the next priced equity round.

2. For fast and simple fundraising.

SAFE notes have standardized, simple legal documents (usually 5-10 pages) with fewer terms to negotiate compared to priced rounds. This allows for a quicker and more streamlined fundraising process.

3. When raising smaller seed/pre-seed rounds.

SAFE notes are well-suited for early funding stages, such as seed or pre-seed rounds, when capital needs are lower. They provide an easy way to get started before larger priced equity rounds.

4. For founder-friendly terms. 

Unlike convertible notes, SAFE notes do not accrue interest, have no maturity dates, and avoid debt on the company's balance sheet, making them founder-friendly.

5. As part of a long-term funding strategy. 

If a startup plans to raise additional rounds later, using SAFE notes initially allows deferring the valuation until they have more data to support a higher valuation.

6. When speed is prioritized over investor protections.

SAFE notes trade-off fewer investor protections for a faster, simpler funding process compared to priced rounds.

How to send a SAFE note

1. Define the terms

The first step is getting really clear on the terms you want on the SAFE note. To do this, work with your legal counsel to determine the key economic terms like the valuation cap, discount rate, amount being raised (investment amount), and any negotiated investor rights.

2. Create the SAFE note agreement

Once you and your legal counsel have landed on the terms, create the SAFE note agreement document by filling out a SAFE note template with the company name, founder name, investment amount, valuation cap, discount, etc. Your lawyer should review it.

Cap table management software providers like Carta and Fidelity can make this process as easy as a few clicks. 

3. Issue SAFE notes and collect the funds

Send the SAFE note agreement to interested investors for eSignature with an eSignature platform. Once the investors sign and you countersign, you can then collect the investment funds from those SAFE note holders.

4. Convert to equity

When the startup raises its next priced equity round, the pre-negotiated valuation cap, discount rate, and investment amount are used to calculate the conversion price and a number of preferred shares issued to the SAFE noteholders in exchange for their initial investment.

SAFE note example

Now, let’s review a hypothetical SAFE note example. 

Startup XYZ is raising a $500,000 seed round from angel investors using SAFE notes with a $5 million valuation cap and 20% discount rate.

Investor A invests $200,000 via a SAFE note.

In this SAFE, the key terms are:

• Investment Amount: $200,000
• Valuation Cap: $5 million 
• Discount Rate: 20%

A year later, Startup XYZ raises a $3 million Series A round at a $10 million pre-money valuation.

To calculate Investor A's ownership from the SAFE:

1. The Series A price per share is calculated as:

$10m pre-money valuation / $5m pre-money shares outstanding = $2 per share

2. With a 20% discount, Investor A's effective share price is:

$2 x (1 - 0.2) = $1.60 per share

3. Investor A's $200,000 investment amount is converted to:

$200,000 / $1.60 per share = 125,000 shares

4. After the Series A, Startup XYZ has:

$5m pre-money shares + $1.5m new Series A shares = $6.5m total shares outstanding

5. Investor A owns $125,000 / $6.5m = 1.92% of Startup XYZ

This example shows that by using the SAFE with a $5m valuation cap and 20% discount, Investor A was able to get shares at a better price than the Series A investors, owning 1.92% of Startup XYZ for the $200,000 investment.

The SAFE allowed Startup XYZ to raise seed funding by giving Investor A future equity rights without setting a premature valuation. The valuation cap and discount benefited the investor compared to the Series A pricing.

SAFE notes vs. convertible notes

SAFE notes are generally considered more founder-friendly because they provide simplicity, flexibility, and control, while convertible notes offer more investor protections but at the cost of added complexity and potential debt obligations for founders.

For founders

The benefit of SAFE notes for founders is that they are simpler and shorter legal documents (usually no longer than 5 pages)  than convertible notes. They also do not have interest or a maturity date, so founders can avoid debt on the balance sheet. 

SAFE notes also provide the following benefits for founders:

• Defer valuation until later priced equity round.
• Allow founders to maintain more control without giving up board seats. 
• Are faster and cheaper to execute than priced rounds. 

Convertible notes, on the other hand, are more complex legal documents that require more negotiation. They accrue interest as a debt instrument. 

Convertible notes also do the following for founders:

• May have a maturity date forcing conversion or repayment.
• Potentially give up more control or board seats to investors.
• Are generally more expensive and time-consuming than SAFEs.

For investors

Now, for investors, SAFE notes do not have interest payments or maturity repayment obligations. They have fewer protective provisions compared to priced rounds. 

SAFE notes have a fair amount of uncertainty around conversion terms until the next round. However, the valuation cap and discount provide a potential upside.

Conversely, convertible notes have interest payments that provide some return payout if there is no conversion. 

With conversion notes, investors also see the following: 

• The maturity date provides pressure for a liquidity event. 
• More protective provisions/controls, like in priced rounds. 
• Established history and familiarity among investors. 

Alternatives to SAFE notes

Convertible notes

Convertible notes are debt instruments that convert into equity at a future date, typically during the next priced equity financing round. They have provisions like an interest rate that accrues, a maturity date when the debt must be repaid if not converted, and often include valuation caps and discounts. 

Convertible notes are more complex legal documents compared to SAFEs, requiring more negotiation and legal fees, but they provide some interim return to investors through interest payments if conversion doesn't occur.

Equity financing

Equity financing refers to raising capital by selling shares of stock and ownership in the company during a priced funding round. It requires formally setting a company valuation to determine the price per share issued to investors. 

Equity rounds are more complicated, expensive, and time-consuming compared to SAFEs or convertible notes. However, equity investors often receive more control, protective provisions, and rights like board seats, making it suitable for larger funding rounds once the company has more traction.

Revenue-based financing

Revenue-based financing provides capital in exchange for a percentage of the company's future revenues until a predetermined repayment cap is reached. It is structured as a loan or debt instrument, but repayment amounts fluctuate based on the company's monthly revenues. 

No equity or ownership is exchanged, making it non-dilutive for founders compared to SAFEs or equity rounds. Revenue-based financing is sometimes used by companies with existing revenue streams looking for growth capital to hit new milestones.

FAQs about SAFE notes

What happens to SAFE notes if a startup is acquired?

If a startup that has issued SAFE notes gets acquired, the SAFE notes typically convert to equity immediately prior to the acquisition. 

The conversion is treated as a liquidity event, with the SAFE investors receiving shares or cash proceeds based on the pre-negotiated terms like the valuation cap and discount rate. SAFE note holders get compensated as if they were existing shareholders in the company being acquired.

What happens if a SAFE note never converts? 

The investor loses their investment if a SAFE note never converts to equity. In extremely rare cases, the investor may be able to negotiate some form of repayment or compensation from the company. Still, there is no guarantee that the SAFE will fail to convert.

Can an LLC issue a SAFE note? 

Yes, an LLC can issue a SAFE note. The standard agreement would likely need modifications, though, and there are potential risks around tax treatment uncertainty that LLC owners should review with their legal counsel.

Wrap-up: Manage your investor cash with Rho

SAFE notes are an instrument startup founders and investors use to simplify the fundraising process prior to the Series A fundraising round. Once you've raised your pre-seed or seed round, you want to make sure the cash you aren't immediately using for operations is put to work, earning yield.

That's where Rho Treasury can help. Once onboarded to Rho, your cash will be invested in government-backed U.S. Treasury Bills with 2-3 business day liquidity, giving you access to market-leading yields on your non-operating cash.

Sign up today to learn more!

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