Start-ups and SAFE notes: Why and how should you use them?

As a start-up raising capital for the first time can be both an exciting and daunting process. Recently early-stage start-ups have turned to using SAFE notes as an effective instrument to help them raise capital. The following article will explain how a start-up can use SAFE notes to connect with investors and outline some key differences between other financial instruments.

What is a SAFE note?

‘SAFE’ stands for ‘Simple Agreement for Future Equity’ and is considered a great way for start-ups to raise capital. SAFE notes have become an increasingly popular fundraising instrument within the start-up scene and are typically used during early-stage or the seed round of capital raising. This is because they tend to be a quicker, cheaper and more founder-friendly alternative to more traditional forms of capital or debt financing.

The idea behind a SAFE note is that the investor provides cash in exchange for a promise to be issued equity sometime in the future. Exactly how much equity will be issued is not fixed at the time of the SAFE note. Instead, the amount of equity will usually be determined according to the valuation of the company at the next funding round. This results in two main benefits to the business:

1. It allows the start-up to defer the valuation of their business to a later date but still raise capital from an investor. This is very important because it is often very difficult to come up with valuations for early-stage start-ups, and the valuation tends to be a big sticking point between investors and founders.
2. Since the investor doesn’t get shares (until the future event), the founders usually do not lose any control over the start-up at this early stage.

How does a SAFE note convert into equity?

The SAFE note usually ‘converts’ into equity if there is a qualifying funding round (ie, a capital raise that meets a minimum threshold set in the SAFE note) or an exit event. At that point, the valuation used during this funding round will be applied to the investment of the SAFE note holder, usually subject to a discount and/or a valuation cap.
It is important to note that a SAFE note will usually apply a discount rate on whatever the valuation is at the next funding round. Much like a convertible note, this discount rate is offered to reward investors for taking the risk of investing earlier than the later round which triggers the conversion. Discount rates tend to be between 10%-30%.

Example of how SAFE note works:

1. Katie invests $100,000 in Startup X through a SAFE note, with a 10% discount.
2. A year later, Startup X raises money on the basis of a $2,000,000 valuation.
3. Katie will now be issued shares on the basis of a $2,000,000 valuation less a 10% discount, being $1,800,000.
4. This means that Katie will be issued shares as if she invested $100,000 on a $1,800,000 valuation.

Valuation Caps: What you need to know

The other key incentive often given to the investor in a SAFE note is a valuation cap. Since the investor is investing without a valuation, they are taking on a risk that the future valuation (at the next capital raise or exit event) might be very high, in which case they will get very little equity for their investment. To minimise this risk, investors often demand that a SAFE note will specify a maximum valuation that will be used even if the actual valuation is higher.

• Using our example above, if Katie’s SAFE note had a $1,500,000 valuation cap, then this would be the valuation used to calculate her equity.
• Accordingly, she would get equity on the basis of $100,000 invested per a $1,500,000 valuation, as opposed to the actual valuation ($2,000,000) or even the discount valuation ($1,800,000).
  In this way, a lower valuation cap will provide an investor with a potentially higher equity percentage at the next round of funding.

Setting a valuation cap in your SAFE note as a founder requires the balancing of different interests. On the one hand, you don’t want to set your valuation cap too high, because this may turn away investors. On the other hand, setting a low valuation cap will mean you may end up handing out a lot of equity to the investor, thus diluting your own shareholding and losing a degree of control.

What’s the Difference Between a SAFE note and a Convertible Note?

You may have also come across convertible notes as a way of raising funds for a startup. A convertible note is a more traditional funding instrument (used outside the start-up ecosystem), and it has a lot of similarities to a SAFE note. In fact, you could probably think of a SAFE note as a convertible note that has been modified to be more founder-friendly.

The convertible note has a few key differences which make it a less attractive option for a founder or start-up. They mostly stem from the fact that the convertible note is essentially a loan, which can also be converted into equity at the choice of the investor. This means that:

1. Like most loans, convertible notes usually include an interest rate on the “investment amount”.
2. A convertible note usually allows the investor to choose between getting a cash payment or conversion into equity when a trigger event occurs.
3. A convertible note usually has a set end date, which means that if no trigger event has occurred, the investment amount must be repaid in cash.
4. The convertible note is a debt instrument, and will be displayed as such on the books of the company.

The points about the investor being able to demand cash repayment at the trigger date or end date are significant. Start-ups, even funded ones, usually do not want to have to pay cash back to investors. Likewise, new investors are usually not happy about their investment being used to pay back these prior “investments” – they want their funds to go towards further growth.

SAFE notes – important

It’s true that many SAFE notes (including the most common documents available to download for free online) still give SAFE note investors the option to be paid back in cash, instead of converting into equity. This is because those templates and free documents are drafted by lawyers working for investors, and not founders. This is exactly why it’s important not to rely on free or downloadable documents, and instead engage a start-up lawyer who is familiar with the start-up landscape who can give you crucial pointers about how to structure your investment. In our experience, investors will usually accept the deletion of this right and commit to only receiving equity as opposed to cash repayment. This is just one of the founder-friendly changes we can make to standard SAFE note templates.

Summary

• A SAFE note’s core function is to enable simple, founder-friendly investment in a start-up, usually in an early stage.
• A SAFE note is a promise by the company to issue equity at a future, pre-agreed event – usually a larger capital raise or an exit event.
• A SAFE note allows founders to avoid coming up with a valuation, which is often a big hurdle to getting funding.
• A SAFE note also means that the founders virtually do not lose any control over the business in the short term.
• A SAFE note usually protects investors through a discount rate and a valuation cap, which are both used to protect the investor from a very high valuation when they finally get issued their equity.
• Unlike a convertible note, a SAFE note should have no interest payable and should always convert into equity (as opposed to allowing the investor to demand repayment in cash).

As a start-up, using the right instrument to raise capital is an important decision that needs to be carefully considered. Given that more investors are becoming comfortable with using SAFE notes as a way to invest in start-ups, founders need to familiarise themselves with how they work.

As SAFE notes are relatively new instruments and are not used much outside of the start-up ecosystem, many lawyers are not sufficiently familiar with the fine details that could have big impacts on a start-up’s future. If you have any questions about raising capital or need any advice on business matters, get in touch (Schedule free consultation) with our start-up lawyers or call us on (02) 9343 0381.