SAFE Notes – What Investors Need to Know
Investing in early-stage companies poses two problems: estimating a company’s value with no tangible worth and protecting early-stage companies from over dilution before their worth is fully established. Pain in the business world until Y Combinator came up with a novel way to do this in 2013, called the SAFE note.
SAFE notes provide VCs and entrepreneurs with a quick and straightforward solution to provide seed financing without long, drawn-out negotiation, onerous loan covenants, or a ridiculous valuation that could harm the investor. Here is what you need to know.
The Simple Agreement for Future Equity (SAFE) is a financial contract used by startup companies to secure seed funding. As advertised in its name, its designed to be simple – and it is – usually 2-3 pages. A SAFE gives an investor the right to convert that investment into equity in a startup if the startup raises financing or sells itself. But why not take equity on day 1 and what’s the upside for the investor?
As Alykhan Sunderji, attorney and Founder of Sunder Legal, puts it, “a SAFE holder is betting that the startup with use this seed capital to get the business of the ground and they will benefit when the Company eventually raises significantly more financing in the future.”
The SAFE Note: Key Elements
“The SAFE holder benefits because they’ve often negotiated for a discount when that financing takes place and their investment converts to equity,” explains Sunderji. “Sometimes, SAFEs discount future converted equity by 10% to 30%. This is one way early stage investors make significant returns,” he adds.
A valuation cap is another way for an investor to get a better price per share than future investors. Instead of providing a percentage discount, the conversion assumes a maximum valuation of the Company, which can also provide investors with a sigificant return if the Company’s future valuation exceeds the cap. Investors can also maintain their ownership share during future equity financing, known as pro rata, by investing extra funds.
SAFEs also have an advantage of being exempt from registration requirements with the SEC. Technically, the Company isn’t issuing equity. It’s issuing a promise to convert to a certain amount of equity in the future, calculated by the valuation given by future investors.
This detail points to their long evolution in new company financings. SAFEs may be new, but they are a much older concept. The SAFE traces its origins to the Convertible Note – a loan that converts into equity at some point in the future.
Using the SAFE, investors get a financial stake in the company but are not immediately shareholders. If “trigger events” such as the above occurs, investments turn into equity. And as discussed above, if all goes well for the startup and the SAFE holder, the SAFE holder will receive a discount.
“Investing in startups is risky, so returns are never guaranteed,” says Sunderji. In the words of Richard Branson, “My philosophy is that if I have any money, I invest it in new ventures and not have it sitting around.”
“Returns vary according to how much you invest when the trigger event occurs and the terms of the SAFE. In the absence of an exit valuation, you may never see a return on your investment,” says VC attorney Alykhan Sunderji.
Benefits of Signing a SAFE Agreement
There are 4 main flavors of SAFEs. Many will have a valuation cap, some will have a discount, and some will have both, giving investors the benefit of whichever calculation is most helpful. Another version of the SAFE does not have a valuation cap or discount, which is used by investors planning to advance shortly before taking part in a total financing round.
Simplicity is the name of the game with SAFE notes. These notes are a few pages, easy to understand, and are not heavily negotiated. They also eliminate startup paperwork, saving investors time because they do not have to approve company decisions or attend shareholder meetings. For early-stage startups, especially those with limited capital, this results in a tremendous benefit, improved agility, and helps them succeed.
SAFEs also give founders flexibility – SAFE notes do not require repayment or maturity for founders, so they focus on starting and growing the business and not worrying about cash flow or insolvency.
Limitations in a SAFE Agreement
As with all instruments, there are drawbacks to using SAFE notes. Despite their simplicity, SAFE notes still reflect the terms of a high-value business deal, where it’s important both investor and founder to understand their risks and how different events will play out financially. Competent legal counsel is critical to obtain a comprehensive understanding of the legalese in these documents.
SAFE notes are increasingly popular – with founders using them to raise funds from angels, VCs, and even friends and family. But they haven’t been around as long as debt, and convertible notes are also appealing to investors. But Alykhan Sunderji says, “Ultimately, the best part of our system is that founders and investors have a number of well trod paths to raising financing for new ventures, and Sunder Legal is happy to navigate those negotiations.”
Richard Branson, the world-class entrepreneur and successful investor says, “An entrepreneur is an innovator, a job creator, a game-changer, a business leader, a disruptor, an adventurer.”
Investing is known to be risky, but you can be safer when you use a SAFE note.
Media Contact
Company Name: Sunder Legal
Contact Person: Alykhan Sunderji
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Phone: (206) 736-3584
Country: United States
Website: sunderlegal.com
