All About SAFE Notes
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What is a SAFE Note?
A SAFE Note is the invention of the Y-Combinator group, a well-known and respected incubator, accelerator and early-stage venture capital group out of Silicon Valley. They identified deficiencies within the standard Convertible Note structure: the interest rate, conversion cap, and liquidation preference. As a result, they developed this new form of security that functioned as an equity transaction rather than a debt transaction, simplifying the process.
SAFE stands for Simple Agreement for Future Equity, and functions similarly to the Convertible Note, except that it is not a promissory note and has no principal or interest. It simply is what it says: an agreement to put money into a company that converts upon qualified financing to equity, alongside new money with the same rights and privileges and a discounted share price.
The Issue with Convertible Notes
When a Convertible Note converts at a lower valuation than the equity round, it receives the same liquidation preference as the equity round into which it converts. This is great for CN holders, who typically get 20% more money back on the liquidation preference than they would have had they investing in the equity round. This effect is multiplied when a company stacks up Convertible Notes, rather than converting them, and becomes a big challenge to manage financially. It also pays out early stage investors at a relatively higher differential rate than late-stage investors—and before founders see money from their own projects. As early stage investors, we don’t really see this as a problem, but it’s easy to see how it could be viewed as such. SAFE notes do not solve this problem.
The interest rate is a blunt instrument we use to force management to stay focused on exiting us because our shares effectively decrease in cost by 8% (typically) for every year they don’t repay or convert us! Again, we don’t see this as a problem.
A valuation cap effects the valuation of the next round of funding and is problematic to the extent the investor may be hurting their return in the long term by pricing the cap too low. The original SAFE note did not include a valuation cap, but the SAFE Notes we consider at CEP all contain a valuation cap, which is quickly becoming the standard. This means that reasonable valuation caps must be set. At the end of the day, investors must be compensated for the excessive risk we take by investing in early stage investments. We absolutely want a valuation cap to compensate us for our risk (e.g. a risk premium) as early stage investors.
The SAFE Note does not result in shares being granted at the time of the investment, but rather a warrant. It may not be recorded on the cap table until conversion, depending on how the company views the obligation. It typically does not come with Board of Directors participation or observer rights.
The other thing to note about a SAFE Note is it typically does not have a maturity date. As structured, it is essentially a zero-interest loan to the company until the time it raises a designated equity round. So, what about early exits? In this event, the standard SAFE Note has a 1x buyout or conversion to the new equity of the acquiring company, but 2x liquidation preference in this event is becoming more accepted, which is what we do with our Convertible Notes.
Unfortunately, since SAFE Notes are not debt, investors can’t write down the investment as bad debt if it fails. Typically bad debt is deducted fully in the same tax year. Equity must be offset by gains elsewhere or taken in small doses over several years. With a Convertible Note, the holder is a creditor in the event of wrapping up of operations where assets remain (admittedly rare in this industry). The SAFE Note is lumped in with all the equity holders and enjoys no preference in distribution of assets at dissolution.
So, Who is a SAFE Note For?
Entrepreneurs love SAFE Notes. They are cheap to execute and are essentially a passive investing vehicle with lower financial downside in the event of success or failure. This is also the reason we don’t typically use them at Community Equity Partners unless they have a very compelling discount, valuation cap, and 2x liquidation preference in the event of premature exit.
We are seeing a trend in the marketplace now where entrepreneurs are reluctant to price a round and then use CN and SN to postpone the valuation issue. The result is often a substantial dilution to the company when new equity invests. This is especially problematic when too many Notes are stacked up with differing valuation caps. Entrepreneurs fall prey to the trap of thinking they are pushing off dilution when doing the opposite. Any sophisticated investor looking at the issue will likely pass on a new round if they believe the founders will be excessively diluted by a conversion of too many notes. Be smart when you consider a SAFE Note (or Convertible Note for that matter) to make sure the entrepreneur has not disproportionately committed to a big conversion/dilution in the future.
When SHOULD you use a SAFE Note?
For a bridge to a milestone/valuation changing event.
For a very early stage investment where pricing the round is not straightforward and you expect to hold for a long time.
When you wish to close a deal cheaply and quickly in order for some external event to precipitate that will convert your warrants to equity advantageously.
When you do not wish to create any more long-term debt on the company’s books (depending on the stage and revenue of the company, we recommend never having more than $1M in convertible debt on the books if it can be avoided).
Red Flags with SAFE Notes:
Multiple SNs stacked up.
Multiple valuation caps.
An entrepreneur that is unrealistically opposed to pricing a round that will convert Notes.
Make sure the entrepreneur has recorded all SN’s as warrants (obligated on the cap table).
What to do when issuing a SN:
The Discount rate should account for the lack of an accrued interest feature.
The valuation cap should roughly correspond to the expected valuation of the next round of capital.
You should seek a 2x liquidation preference in the event of an early exit.
We always advise a BOD or at least observer rights with an investment.