Published by: Jamie Tredgold, Support Legal
Are you a startup or early-stage business considering raising capital from friends, family and/or investors? If so, then it is likely that you’ve heard of SAFE notes (which stands for Simple Agreement for Future Equity) – the documents commonly used in such a fundraising round. But what exactly are they and why have they become so popular in the startup ecosystem in recent years? In this note we’ll explore what these agreements are, how they work and why they have become so popular with savvy entrepreneurs and investors alike.
A brief history
In the world of startups and venture capital, there are always new and innovative ways to fundraise. One such method is the SAFE note, developed by Y Combinator, the fabled American technology startup accelerator. This investment instrument is an alternative to traditional equity or debt financing, offering flexibility for both the investor and the startup.
While SAFE notes are relatively new, they are gaining popularity among startups and investors alike, with startups like Dropbox and Airbnb using it in their early funding stages. With its advantages such as simple terms and no maturity date, it’s no surprise that the SAFE note is changing the game for fundraising in the startup world.
Why use a SAFE note?
A SAFE note, a simple form of convertible loan agreement, is a type of investment document that is increasingly common in startup funding. Unlike traditional equity or debt financing, SAFE notes offer investors the opportunity to purchase future shares in a company at a pre-determined valuation. This means that investors can provide funding to a startup without having to establish the value of the company upfront. This provides a sense of ease for both the investor and the startup, especially in the early stages when valuing the company can be difficult. Additionally, a SAFE note is relatively straightforward, easy to understand and typically requires less legal fees than traditional investment options to implement.
Difference between a SAFE note and a standard loan or investment
If you’re an entrepreneur, getting funding for your new venture can be a major challenge that you have to tackle. You’ll have to think through various financing options that are available to you. In addition to a standard share purchase, two of the most common options are the SAFE note or a loan financing. It’s important to know that while each option can help you get capital for your business, they have some key differences that you should carefully consider.
A SAFE note is a type of investment that grants the investor the right to future equity in your company but does not include an interest rate or maturity date. On the other hand, a loan typically involves a fixed interest rate and set repayment terms. Which option is right for you depends on your specific business needs and goals.
Advantages and disadvantages
One of the advantages of using a SAFE note is that it is a simple and efficient way to invest in a company without the legal complexities of traditional equity investment. Additionally, investors can avoid the valuation negotiations that come with traditional equity investment. However, SAFE notes also come with their own set of disadvantages. For example, they do not offer the same level of investor protection as traditional equity investment, and there is a possibility that the company may never convert the SAFE note to equity.
Overall, while SAFE notes may be beneficial for some investors, it’s important to carefully consider their advantages and disadvantages before deciding to invest.
How to structure a SAFE note agreement
Investors and startups both strive to minimise risk when it comes to a potential investment, which is why a structured framework is necessary to establish an equitable risk-sharing agreement between the two parties. A SAFE note offers a unique form of investment in which the investor funds the startup in exchange for equity at a future date.
To structure a SAFE note agreement, there are several key elements to take into account such as the valuation cap, discount rate, and other standard terms and conditions. By delving into these components, startups and investors alike can create a mutually beneficial agreement that maximizes the potential for a profitable return while minimizing risk.
What founders need to know
Entering into a SAFE or any other form of convertible loan note agreement can be a tricky process for founders. It is important to understand the terms and conditions of the agreement before signing on the dotted line. One key consideration is the conversion discount, which determines the conversion price of the loan into equity. Founders should also pay attention to the valuation cap, which sets the maximum valuation of the company at the time of conversion. These mechanics will determine who much equity the founders will cede to SAFE note holders upon the occurrence of a conversion event. Additionally, founders should be aware of any clauses that may trigger default or affect the company’s future financing options.
Taking the time to thoroughly evaluate the terms of a convertible loan note agreement can help founders make informed decisions and avoid potential pitfalls in the future. What happens if the company fails?
Investing in a startup can be a risky endeavour, and even with a well-drafted SAFE note, there’s no guarantee that the business will succeed. Unfortunately, if the company does fail, SAFE note holders may find themselves at the bottom of the list when it comes to recouping their investment.
Generally speaking, in the event of a liquidation, investors who hold debt (like a traditional loan) or who own preferred stock are paid first, while those who hold common equity (like SAFE note holders) are last in line. That said, each situation is unique, and there are occasionally ways for holders of SAFE notes to recover some of their investment if a business goes under. The important thing is to be informed about the risks before investing and to carefully review the terms of any agreement before signing on the dotted line.
In conclusion, SAFE notes are a viable option for startups and investors looking to avoid the legal complexities and costs of traditional equity investment. However, it is important to understand both the benefits and risks of investing with a SAFE note before entering into an agreement. By understanding the terms and conditions of the SAFE note, founders and investors alike can make informed decisions and maximize their chances of success.
This material is provided for general information only. It does not constitute legal or other professional advice.