Are SAFE Notes Safe For Investors?

Written by | March 17, 2021

If you’ve been around the startup world, especially early-stage companies, you probably have either run into or heard about SAFE notes. These instruments have gone through a bit of an evolution, and offer companies and investors a different path than traditional initial equity investment or debt.

For the uninitiated, SAFE is an acronym for Simple Agreement to Future Equity. In 2013, Y Combinator, the seed money startup accelerator, introduced this note to help early-stage companies raise money. The impetus was that convertible notes didn’t give founders flexibility, and could potentially hamper future investments. Therefore, it introduced a pared-down instrument that had some features of a convertible note, and the SAFE note was born. For a deeper dive, go to Y Combinator’s SAFE User Guide. Drawing from my experience, as well as the information in that guide, here is a brief look at SAFE notes, their benefits and their potential issues.

What Exactly Is A SAFE Note?

To understand a SAFE, the first thing to understand is what it isn’t. A SAFE note isn’t debt. It’s a promise to issue future equity as long as certain terms are met. In somewhat more technical terms, it’s a nondebt convertible security. In simple terms, an investor will give a startup money and receive a promise to get equity, usually at a predetermined price when certain milestones are met. In many cases, unless the company is bought, the promise of future equity happens solely at the founder’s discretion.

Features Of A SAFE Note

There are some interesting features of a SAFE note that deserve highlighting. Most SAFE notes have the following:

• Valuation cap: a predetermined valuation as to what the note will convert to in equity. This is important since it creates certainty for the investor and the company.

• Discount: a predetermined discount to what the note will convert to in equity once a triggering event occurs — usually the raising of a new round.

• No maturity date: According to Y Combinator, “A SAFE is designed to expire and terminate only when a safe holder has received stock, cash or other proceeds, in an Equity Financing, Liquidity Event or Dissolution Event — whichever occurs first. In theory, a safe could remain outstanding for a long time without the need to ‘extend’ any dates or time periods.”

The purpose of all of these features is to make things as simple and clear as possible for the startup and the investor.

Benefits To The Company

A SAFE note is a much less onerous agreement than a convertible note. The main selling point is there are free templates available, the argument being it’s so simple you don’t need to involve an attorney, at least for the initial drafting. Normally there are also no interest payments or an agreed upon end date. In other words, the SAFE note doesn’t have a set time (maturity date) like convertible notes, where the holder of the note can convert the note into equity. There also usually isn’t a requirement to pay back the principle if the company fails or isn’t purchased. A SAFE note provides an influx of capital without the restrictions of covenants, promises of repayment or initial control or dilution issues of a direct equity issuance.

Benefits To The Investor

• Clarity on equity conversion: One of the most valuable benefits is clarity of how much equity is being issued. In many convertible debt notes, the conversion price and amount can be opaque, especially if an open round of funding is involved. Unclear paperwork causes the following issues:

1. Confusion over whether the conversion is pre- or post-money of the new raise.

2. If there is an open round and your valuation is postmoney, you technically can’t convert until the round is closed. If you have straggling investors, your conversion is delayed. This causes uncertainty for you, the startup, and existing and new investors.

• Ease of entry and startup’s comfort: If you are a seed/early stage investor, a SAFE note is an easy way to invest in a company post the initial raise (e.g., friends and family) without the paperwork and effort of a convertible note. Also, convertible notes usually come with obligations that might hamper future investment from other parties (e.g., interest payments, investor subordination [debt gets paid before equity], etc.).

Issues To Consider As An Investor

SAFE notes offer none of the protections that convertible equity does. There is no liquidation preference, no guarantee you’ll get your money back and no guaranteed timeframe for equity conversion. However, this might not be that big of a deal considering the stage of investment. SAFE notes are best used in the early stages of a company, pre-Series A.

If an investor is looking for the protection convertible notes provide, it’s probably better to pick a company that is on better financial footing than a SAFE note candidate. Investors can trade these protections for a higher conversion discount and lower conversion cap. Charles McCormick, partner at McCormick & O’Brien, makes a compelling argument for this in his SAFE note article.

Like any investment vehicle, SAFE notes fit a particular niche. Knowing their limitations and determining whether one matches your needs and preferences upfront will help prevent future investor heartburn.

The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.
This article was first published on Forbes Finance Council, Mar 17, 2021.