What is a SAFE Note?

When early stage companies set out to raise initial capital they are often presented with multiple fundraising vehicles to accomplish their goal. While most entrepreneurs are familiar with Convertible Notes[1] and Priced Rounds[2], less may be familiar with SAFEs and the associated key terms. One frequent question NEXT[3] receives is: “What is a SAFE?” A SAFE is a Simple Agreement for Future Equity, and while SAFEs have been ubiquitous on the west coast since Y-Combinator’s[4] introduction of the SAFE in 2013, the SAFE has only recently gained widespread adoption by east coast investors.

Similar to a Convertible Note, a SAFE converts into equity upon a specified future event— that “specified future event” is typically a company’s Next Equity Financing[5]. However, unlike a Convertible Note, a SAFE is not considered debt, which means it does not have an interest rate and a set maturity (or expiration) date. This allows an early stage company the flexibility of raising capital via a convertible instrument, without the looming deadline of a specified repayment or maturity date. SAFE holders can best be described as early investors into a future Priced Round.

Inevitably, the next question will be: “What are the key terms of a SAFE?”

The two most important terms of a SAFE are the Valuation Cap[6] and the Discount[7]. Either the Valuation Cap or the Discount will be used to determine the price per share a SAFE converts at—in most cases—upon the happening of the Next Equity Financing. At the time of the Next Equity Financing, the company will calculate the conversion price per share of the SAFE using the Valuation Cap and the Discount. The calculation that produces the lowest price per share upon conversion will be utilized. More often than not, the SAFE’s Valuation Cap will be applied if a company continues to grow and rapidly increase in value. Nevertheless, the Discount provides downside protection to a SAFE investor in the event the valuation of the company’s Next Equity Financing is less (or marginally higher) than the Valuation Cap of the SAFE.

The Company—albeit with investor influence—must determine what percentage and amount to set the Discount and Valuation Cap at, respectively. The industry standard Discount continues to be twenty percent (20%), with upward or downward adjustment in exceptional cases. Although the Discount can be anchored to an industry standard with ease, the Valuation Cap cannot. A Valuation Cap is a forward looking, arbitrary amount set by the company based on numerous factors including, but not limited to, the (1) experience of the founding team, (2) market size and potential, (3) proof of product, and (4) previously completed financings, among others. On one hand, setting the Valuation Cap too low may cause a company to undervalue itself and sell too much, while on the other, setting the Valuation Cap too high may drive off investors. A good rule of thumb is to look to sell between fifteen and twenty-five percent (15-25%) of your company in each financing round.[8]

Admittedly, any stage of capital raising can be perplexing, and undoubtedly involves more considerations than any brief overview can provide, from setting a proper valuation cap to compliance with securities laws. As such, competent counsel should always be consulted before conducting a SAFE offering.

Please contact us if you have any questions regarding why a SAFE may be the right (or wrong) tool for your upcoming fundraising efforts.

 

By Hunter Haines, Associate NEXT powered by Shulman Rogers

[1] https://next.law/fundraising/convertible-note/

[2] https://carta.com/blog/convertibles-safes-priced-rounds/

[3] https://next.law/

[4] https://www.ycombinator.com/

[5] A “Next Equity Financing” can be defined as the next time the Company issues equity securities in a single transaction, or series of related transaction whereby a specified minimum amount of capital is raised.

[6] A “Valuation Cap” is the maximum valuation of the company at which the SAFE converts into capital stock at the time of the Next Equity Financing, regardless of the valuation agreed to by the company and the new equity investors.

[7] A “Discount” is a percentage reduction of the price per share in the Next Equity Financing.

[8] For example, if you are looking to raise $1,000,000, a pre-money Valuation Cap of $4,000,000 results in the sale of twenty percent (20%) of the company after the transaction is completed ($4,000,000 + $1,000,000 = $5,000,000. $1,000,000 / $5,000,000 = 0.2 or 20%).

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