It’s important for investors to understand how the conversion of their notes to equity could influence the size of their personal stake in the business. ~ Ian Wright, Managing Director, Business Financing
What is one thing a founder should know about a SAFE note?
SAFE notes (or simple agreement for future equity) are vital for startup businesses looking to attract investors, typically before their seed rounds. But do you know what sets these relatively new investment funds apart from more traditional options? Or how about the risks to both you, as a founder, or your investors?
Many founders and startups are unsure how to field these questions. That’s why we’re the top advice from 14 financial experts and leading entrepreneurs on what you should know about SAFE notes and what these investments mean for your startup.
- Know Your Business’ Worth First
- Provides No Interest Rate or Maturity Date
- Offers Better Negotiation and Conversion Rates
- (almost) Never Offer Uncapped Safe Notes
- Delaying Conversion Until You’re Profitable
- SAFE Noteholders Lack Direct Company Involvement
- Allows for Quicker and Easier Investment Deals
- Designed to Protect Investors
- Discounts Drive Investor Loyalty
- Cash Relies on Key Converting Events
- Don’t Forego a Lawyer’s Expertise
- Must Be Part of the C Corporation Capitalization Table
- Don’t Offer Similar Protections as Traditional Investments
- Account for Possible Ownership Dilution
Know Your Business’s Worth First
It’s important to understand that SAFE notes have classifications, and a founder should never use an uncapped SAFE note unless they fully understand the value of their company. Although many look at the uncapped SAFE note as being riskier to the investor and more secure for the entrepreneur, not knowing the true value of your company can quickly flip that script.
SAFE notes allow investors to purchase preferred stock at discount prices, allowing them to gain greater ownership or cash out on those greater values. However, a founder who doesn’t fully understand the worth of their company and offers an uncapped SAFE note, could find their ownership diluted or assets being turned over to investors if they greatly underestimate the value. Therefore, before offering this type of SAFE note, it’s critical to know your business’ potential worth to mitigate taking a dramatic hit to your finances.
Provides No Interest Rate or Maturity Date
The alternative to SAFE notes is convertible notes, but these are forms of debt, carrying interest rates of 2%-8%. By using SAFE notes, a company can cut down on expenses by not having to pay interest. Also, convertible notes have a maturity date when the company has to either repay the principal plus interest or issue preferred stock. SAFE notes do not have a maturity date, which makes them a safer option in case the company does not perform as expected.
Offers Better Negotiation and Conversion Rates
Unlike convertible notes, SAFE notes have fewer things to negotiate. Investors just have to worry about discount rates and valuation caps. Nowadays, SAFE notes are more often considered than convertible notes by investors because of these negotiation terms. If we talk about SAFE notes, a SAFE note holder doesn’t worry about being threatened over a maturity date or any conversion price issue down the line. While on the other hand, convertible note holders will always find themselves being worried about interest rates and cash flows.
(almost) Never Offer Uncapped Safe Notes
The most crucial part of the SAFE note is the valuation cap. Only offer uncapped SAFE notes if you have a strong understanding of your company valuation over the long term, so investors aren’t dealing with diminishing returns. It almost always makes sense to use capped SAFE notes and make your first cap relatively low and simple, between $1 to $3 million. Set up your notes with a minimum percentage of the equity cap rather than the total value, and avoid multiple initial investment rounds with differing limits—they’re very risky.
Delaying Conversion Until You’re Profitable
One major perk of the SAFE note is its flexibility, allowing founders to maintain more control over how repayment for the note happens. Unlike a debt instrument, a SAFE note doesn’t have a maturity or end date, so you won’t be forced to convert a note to equity until your business succeeds. Using SAFE notes can help you delay conversion so that you’re not dealing with mounting debt or tight deadlines at the worst possible time. SAFE notes pay off well in favor of the investor, but “repayment” doesn’t come at the risk of business operations.
SAFE Noteholders Lack Direct Company Involvement
SAFE Noteholders are not given any voting rights and in most cases, they have no direct involvement in the company. They have very little, if any, say in how the company is run. This can be a good or bad thing depending on your perspective. If everything goes well, it’s great! The investor has put their money into something with very little strings attached.
On the other hand, if things go south, the investor may feel powerless and frustrated. In addition, major decisions such as selling the company require unanimous consent from all SAFE note holders, which can be difficult to obtain.
Allows for Quicker and Easier Investment Deals
Selling a SAFE note is a great alternative if you’re not ready to set a valuation for a company. When you sell traditional equity to an investor, you need to set a valuation with strong data to back it—and investors typically want to negotiate. The SAFE note provides a single, standardized form typically not subject to negotiations for faster, simpler investment options. This simplicity doesn’t weigh the deal too heavily away from the investor, as they typically receive deep discounts on preferred stock, often earning them 10x their original investment.
Designed to Protect Investors
A SAFE note is a type of investment vehicle that is often used by startup companies. While there are many different types of SAFE notes, they all share one key characteristic: they are designed to protect the investor in the event that the company fails. In essence, a SAFE note ensures that the investor will not lose money if the company does not succeed.
For founders, this means that it’s important to understand the terms of the SAFE note before accepting any investment. Otherwise, they may find themselves in a situation where they are unable to repay the investment, which could damage their reputation and hinder their ability to raise future funding.
Discounts Drive Investor Loyalty
SAFE notes sometimes provide investors with discounts. They apply discounts with different percentage margins (10%, 20%, and 30%) on a future converted equity. This is a huge deal for investors because they get discounted shares on future financing. I have been buying shares using a discount offer. The benefits that I’ve gained from being a SAFE note holder have left me no choice but to stay a loyal SAFE note holder. For example, In the year 2019, I was offered a 20% discount and achieved a valuation of $10m, the shares I purchased later were worth $10, which I bought for $8.
Cash Relies on Key Converting Events
SAFE notes can only be converted into cash unless it turns into equity. SAFE notes can also be repaid in any different types of events. Three types of event clauses occur in a SAFE agreement. For example, a dissolution event describing the voluntary or involuntary termination of the company; a liquidity event where the founder feels their equity has no market value to trade on, which allows investors and traders to cash out before it’s too late; and the last event is insolvency, which occurs when a person can no longer meet their financial obligations, which leads the business to bankruptcy.
Don’t Forego a Lawyer’s Expertise
Enlist the help of a lawyer to either draft a legally binding SAFE note or understand the legal jargon on the documents. Just because many entrepreneurs think that safe notes are fairly easy instruments and terms are comprehensible as there are no end dates or interest payments to the structure or even if it’s just less than five pages, it doesn’t mean that you should forego a lawyer’s expertise. Safe notes are relatively new, and some founders and investors have a thing or two they may be unaware of, so hiring a lawyer ensures that you stay on the safe side of legal matters.
Must Be Part of the C Corporation Capitalization Table
Your company must be included on the C Corporation capitalization table to be eligible for a SAFE note arrangement (rather than an LLC). Simply put, a C Corp is a company with a board of directors or management that is taxed twice (income and salary). LLCs do not have one or more owners, but instead have multiple partners or members. C A certificate of incorporation and a “cap table” are usually included with corporations. A capitalization table is simply a listing of which entities possess which assets, such as shares and stocks.
Don’t Offer Similar Protections as Traditional Investments
One important thing that a founder should know about SAFE notes is that these types of investments don’t always have the same protections as traditional investment vehicles, such as loans or equity. For example, SAFE notes usually do not carry a fixed interest rate or repayment schedule. Instead, they often have what’s known as a “drawdown structure”, meaning that investors can choose to receive their investment back at regular intervals or decide to keep it in the business until an agreed-upon date.
Additionally, it’s important for investors to understand how the conversion of their notes to equity could influence the size of their personal stake in the business. For example, if the conversion rate is lower than the current price of shares, it could mean that the founder ends up with a much smaller ownership stake than originally agreed upon.
Account for Possible Ownership Dilution
The diluting component of a SAFE note may be disregarded or even appear tempting when seeking smaller sums of money from less experienced seed and angel investors. However, things might swiftly get worse for everyone concerned. Business owners frequently confuse the potential base for an equity round with the cap of the SAFE note’s valuation. A minimum premium on the next round of funding may be implied by any discounts offered on the notes.
It’s important for investors to estimate how the conversion of the notes into equity would affect their own individual shares in the company. Using SAFE notes further puts the problem off to the future. Instead of resolving a problem, it raises the possibility of a brand-new one. Many business owners may experience a hangover-like effect because they suddenly own less of their firm than they thought they did since they neglected to account for the possibility of dilution.