SAFE Note 101

Most news we see in newspapers about startup fundraising is done through equity financing. We don’t see many cases of debt financing or financing through SAFE notes. However, I am seeing SAFE note slowly gaining popularity among founders and investors in Bangladesh. It is quite an effective instrument for fundraising at early-stage startups. In today’s newsletter, I will share my learnings about SAFE notes from my experience of raising funds through them.

What is a SAFE note

SAFE stands for “Simple Agreement for Future Equity”. Instead of investors receiving shares upfront, a SAFE note allows them the right to obtain equity in the future. Typically this future date is connected with a trigger event like the next financing round, acquisition or something mutually agreed by the investors and founders. One thing that needs to be clarified is it is not a debt instrument. It’s a convertible financing that promises equity at a future date and doesn’t come with maturity dates or interest rates like debt instruments.

Why Should Startups Consider SAFE Notes as a Fundraising Instrument

1. Flexibility in Valuation: This is particularly true for early-stage startups. Considering they have little data compared to later-stage businesses, it is comparatively tougher to agree on a valuation at an early stage of business. A SAFE note can be mutually beneficial as parties don’t have to immediately agree on the valuation during fundraising through a SAFE note.
2. No Immediate Dilution: SAFE is a commitment to issue shares at a later date. It allows founders to raise funds without immediately giving up ownership or control of their company. This means they can maintain a larger stake in their startup during its early stages.
3. No Interest or Repayment Obligations: SAFE notes do not accrue interest or have repayment obligations. This relieves the startup from the financial burden of repaying investors the way debt instruments do.
4. Low Legal Costs: An equity or debt financing round involves a complex set of documents, and lawyer involvement that comes with huge costs. Due to their simplicity, SAFE notes typically involve lower legal costs than more complex financing arrangements. This can make fundraising cost-effective for startups.

Key Segments in SAFE Note

1. Valuation Cap: A valuation cap in a SAFE note sets the highest price at which the investor's investment converts into equity. This protects investors by ensuring a fair price, even if the company's value rises. Suppose you are raising funds using a SAFE note with a USD 10Mn valuation cap. It means no matter how much the valuation is in the next financing event, investors of this SAFE note will receive shares at a maximum USD 10Mn valuation.
2. Discount Rate: The discount rate allows investors to convert their investments into equity at a lower price compared to future investors. Suppose you are raising funds using a SAFE note with a 10% discount rate. It means during the next financing event, investors of this SAFE note will receive shares at 10% less price than the investors of the equity financing round. If equity financing investors receive each share at USD 100, SAFE note investors per share price will be USD 90.
3. Most Favored Nation: When a SAFE does not have a valuation cap or a discount rate, it is said to have a “Most Favored Nation” clause. This means the SAFE note investors receive the same conversion terms as those offered to investors in the equity/SAFE future financing round.

Pre-Money & Post-Money SAFE Note

Pre-money and post-money are popular terms in discussing startup valuation. In the simplest terms, pre-money valuation+amount of investment = post-money valuation. It is an important point of discussion while negotiating SAFE notes with valuation caps. The biggest point of distinction between pre-money and post-money SAFE is what we include in the company capitalization calculation.

1. Pre-Money SAFE Note: A Pre-Money SAFE doesn't consider conversion of SAFEs while calculating the equity. So it makes how the cap table will look like after conversion quite confusing for all parties.
2. Post-Money SAFE Note: With a Post-Money SAFE, the conversion of shares considers all the shares issued to other investors (including those with convertible notes). Post-money SAFE calculation ensures proper clarity on which investor will own how much after conversion.

Types of SAFE Note

1. Valuation Cap, No Discount: A valuation cap sets the maximum valuation at which a SAFE note investor's investment converts into equity during a subsequent financing round. This protects investors by ensuring they receive favorable conversion terms even if the company achieves a higher valuation during the trigger event.
2. Discount, No Valuation Cap: A discount provision allows investors to receive equity at a discounted price compared to the next round equity investor. Discount allows investors to have a safety cushion that their SAFE investment will have some benefits in subsequent rounds of financing in terms of dilution.
3. Valuation Cap and Discount: Some SAFE notes provide both valuation cap and discount. In such a case, SAFE investment gets converted into equity based on the comparatively more favorable option between these two (whichever provides a higher benefit to the investor).
4. No Valuation Cap, No Discount: Generally the SAFE notes that neither offer valuation cap nor discount has the Most Favoured Nation (MFN) clause included. It helps as a protection to investors in case future some other investors invest in SAFE notes with more favorable terms.

Some Good Learning Resources

1. SAFE Financing Documents - YC
2. SAFE Note Calculator - Carta
3. Post & Pre-Money Comparison
4. What is a SAFE-AL