SAFE Notes Explained
SAFE is an acronym for simple agreement for future equity. Like the name suggests, a SAFE Note is an equity financing instrument designed to accelerate the seed funding round for startups. It is a short, standard document used by entrepreneurs and investors as an alternative to convertible debt.
How does a SAFE Note work?
Put simply, an investor receives a contractual right to receive equity (i.e., shares) in a future priced round – meaning no specific share price needs to be determined at the time of the raise. The investor gains the right to convert this amount into equity upon the eventuation of a predetermined trigger event. In return, the startup receives an investment amount, usually as part of a seed funding round.
Many startups prefer SAFE Notes because unlike convertible notes, they are not a debt and do not accrue interest.
Trigger event
The predetermined trigger event is the event that initiates the conversion of the SAFE Note into equity. The trigger event will often be a priced equity round by the company, typically the next funding round. It might also be an exit event such as an initial public offering or a liquidation event.
Because a SAFE Note is not a debt, there is no interest rate or maturity date.
Valuation caps
One of the most important features of a SAFE Note is the valuation cap. Valuation caps are investor friendly. The valuation cap sets the maximum company valuation for calculating the share price at which the investor’s money converts to equity.
If the valuation of the company falls below the cap, the SAFE Note will convert to shares at the price of the priced round. If the valuation cap exceeds the cap, the investment will be converted at the amount stated in the cap. This ensures that seed investors are rewarded for their early investments in the company and protects them from excessive dilution in subsequent financing rounds.
Discount
Discounts are also investor friendly. A conversion discount rate allows investors to convert into equity at a discounted price compared to the price paid by new investors. This incentivises early-stage investors by ensuring that they receive more shares for their initial investment than if they were participating in the priced equity round normally.
Types of Safe Notes
Usually in a SAFE Note, the only negotiable details are the valuation cap and discount rate. However, they may also contain Most Favoured Nation (MFN) clauses and pro rata rights.
Most Favoured Nation (MFN)
MFN clauses protect early-stage investors so that if better terms are given to future investors at a later date, those terms are automatically inherited by SAFE investors. For example, if an entrepreneur raises $500,000 with a valuation cap of $4 million and then subsequently raises an additional $500,000 with a valuation cap of $2 million from a different investor, then the entrepreneur has granted more favourable terms to the later investor when compared to the first investor. In these circumstances, a MFN clause would kick in and provide the first investor with the lower valuation cap of $2 million, so that the first investor is subject to the same (more favourable) terms as the later investor.
Pro rata rights
Pro rata rights give investors the right to participate pro ratably in a future financing. Pro rata rights protect investors by preventing dilution and allowing them to maintain their percentage after the priced equity round. Sometimes investors will ask for pro rata rights two or four times their current ownership or for a specific percentage of the next financing. However, this can cause issues for entrepreneurs later by limiting their long-term financial options.
Types of SAFE Notes include:
Valuation cap, no discount: the SAFE Note includes a maximum company valuation but no discounted price per share.
Discount, no valuation cap: the SAFE Note includes a discounted price per share but no maximum company valuation.
Valuation cap and discount: the SAFE Note includes both a maximum company valuation and a discounted price per share.
MFN, no cap, no discount: the SAFE Note entitled the investor to the same terms as subsequent investors, with no valuation cap or discount.
How can we help you?
SAFE Notes can be an effective instrument to accelerate the seed funding round and allow startups to raise capital. However, if you are going to use a SAFE Note, it’s important that you understand and carefully consider the terms of your agreement.
Merton Lawyers are experienced in the start-up landscape and can provide expert advice to entrepreneurs and investors alike on how to structure their investment. To discuss how we can assist you, please contact our corporate team on 03 9645 9500 to arrange for an initial consultation.
