SAFE Notes: Everything You Need to Know for Startup Funding
Explore how SAFE notes work, their benefits and risks, and key funding terms. Learn how they compare to convertible notes and optimize your investment strategy. 9 min read updated on January 15, 2025
Key Takeaways:
- SAFE notes provide a flexible, cost-effective way to raise startup capital.
- They defer valuation decisions until a triggering event, simplifying negotiations.
- Risks include dilution and potential delays in equity conversion.
- Pre-money and post-money valuations impact investor ownership percentages.
- SAFE notes are ideal for early-stage startups seeking streamlined funding solutions.
SAFE notes, or Simple Agreements for Future Equity, are a flexible way for startups to raise early-stage funding for their business. Initially introduced by Y Combinator in 2013, SAFE notes can be a more advantageous alternative to traditional convertible notes for both startups and investors, as they simplify the fundraising process during the very initial stages of a business venture.
This guide explores what SAFE notes are, how they work, their benefits, risks, and essential considerations for startups and investors.
What Are SAFE Notes?
SAFE notes are agreements that allow startups to raise capital by offering investors the promise of future equity, rather than immediate ownership. Unlike traditional debt instruments, SAFE notes do not accrue interest or have a fixed repayment schedule. Instead, they convert into equity when a triggering event occurs, such as a priced equity round or the sale of the company.
Because of this, SAFE notes are often the preferred method for fundraising. Their simplicity, lack of maturity dates, and flexibility makes them beneficial for both investors and entrepreneurs alike.
For example, investors can benefit from mechanisms like valuation caps and discounts, which allow them to acquire shares at favorable terms during the conversion. On the other hand, startups can benefit from using SAFE notes due to their ease of execution and lower legal costs compared to traditional funding agreements.
How Does a SAFE Note Work?
SAFE notes work by delaying the valuation of a startup until a future equity round. For businesses that are in the very early stages, it may be difficult to properly calculate an accurate return on investment. For this reason, SAFE notes can be beneficial for startups by eliminating the need for complex negotiations during the early stages of growth. Here’s how the process works:
- Investor Agreement: First, the investor provides funding in exchange for a SAFE note, which outlines the terms of conversion into equity.
- Valuation Cap and Discount: These terms determine how many shares the investor receives during conversion. A valuation cap sets the maximum company valuation for calculating shares, while a discount provides a percentage reduction from the share price.
- Trigger Event: Conversion occurs during a qualifying equity round, acquisition, or liquidation. The SAFE note converts into shares based on the agreed terms, aligning with the company’s new valuation.
For example, if a startup raises funds using a SAFE note with a $5 million valuation cap and later raises equity at a $10 million valuation, the SAFE investor’s shares are calculated using the $5 million cap, giving them a more favorable position.
Types of SAFE Notes
SAFE notes come in several variations to accommodate different funding needs and investor preferences. Each type has unique implications for startups and investors, influencing ownership stakes and return on investment.
Cap Only
A cap-only SAFE note includes a valuation cap but does not offer a discount.
This means the investor’s conversion price is determined by the valuation cap during an equity round, regardless of the actual valuation. While cap only SAFE note provides investors with clear protection against overvaluation it may not be ideal for startups in their early stages.
Discount Only
A discount-only SAFE note offers a percentage discount on the share price during an equity round, without setting a valuation cap.
This means the investor’s conversion price is lower than that of new equity investors, reflecting their early support.
This type of SAFE note works well for startups with higher confidence in their valuation but needing quick funding without negotiating valuation caps. It’s suitable for ventures in mid-stage growth where founders want to incentivize investors without limiting their future valuation.
Cap-and-Discount
Cap-and-discount SAFE notes combine both features, giving investors a valuation cap and a discount on the share price. During conversion, the investor benefits from the more favorable of the two terms.
This type of SAFE note is highly flexible, making it ideal for startups seeking to attract a wide range of investors while providing robust incentives. It’s suitable for ventures in advanced seed stages or preparing for Series A funding, where attracting larger investors requires competitive terms.
MFN (Most Favored Nation)
These notes allow investors to adopt the most favorable terms offered to subsequent SAFE note investors.
For example, if a later investor receives a lower valuation cap or a higher discount, the MFN clause ensures earlier investors benefit from the same terms. This type of SAFE note is well-suited for early-stage startups anticipating multiple funding rounds. It reassures initial investors while allowing the startup flexibility in structuring future agreements.
History of Convertible Notes and SAFE Notes
Before SAFE notes were introduced, convertible notes were widely used in startup funding for decades. They allowed investors to provide funding that later converted into equity. However, convertible notes had drawbacks, including interest accrual, maturity dates, and potential legal complexities.
Due to these drawbacks, Y Combinator introduced SAFE notes to eliminate issues of debt and complex ownership terms. Since then, SAFE notes have become an attractive option for early-stage fundraising for startups and new ventures.
SAFE Notes Versus Convertible Notes
While both SAFE notes and convertible notes aim to simplify early-stage funding, they have several important differences.
First, SAFE notes are agreements, not debt instruments, and lack interest or repayment obligations. Convertible notes, by contrast, are debt instruments that accrue interest and often have maturity dates, which can pressure startups to repay or convert within a specific timeframe.
For investors, SAFE notes offer the advantage of clear terms and straightforward conversion. However, the lack of a maturity date may delay returns compared to convertible notes. Startups benefit from lower legal costs and reduced negotiation complexities when using SAFE notes.
Benefits of Using SAFE Notes
SAFE notes offer several advantages for startups and investors. Startups benefit from the simplicity and cost-effectiveness of SAFE notes, as they avoid the need for immediate valuation negotiations. This allows founders to focus on growth rather than legal formalities.
Additionally, the absence of maturity dates provides flexibility, ensuring startups are not burdened with repayment deadlines.
For investors, SAFE notes provide attractive terms like valuation caps and discounts, which enhance return potential. These instruments also simplify the investment process, making them ideal for early-stage deals where time is of the essence.
Drawbacks of Using SAFE Notes
Despite their advantages, SAFE notes have limitations. For startups, issuing multiple rounds of SAFE notes can lead to dilution, reducing founder ownership and complicating future funding rounds. Investors may face indefinite delays in equity conversion, especially if a triggering event is postponed.
Compared to traditional equity agreements, SAFE notes may lack the legal protections and detailed terms investors seek. Startups must carefully manage expectations and ensure clear communication with investors to mitigate these risks.
Risks of SAFE Note Dilution
Dilution occurs when a company issues additional shares, reducing the ownership percentage of existing shareholders. Multiple SAFE note rounds can significantly dilute founder and investor stakes.
For example, if a startup raises funds from several SAFE investors with varying terms, the cumulative dilution can complicate ownership structures and impact decision-making.
Startups should model the potential impact of SAFE note rounds on ownership and future valuations. Transparent communication with investors and careful management of funding rounds are essential to minimizing dilution risks.
SAFE Notes and Taxes
Tax implications for SAFE notes depend on the jurisdiction and specific terms of the agreement.
For startups, SAFE notes are generally treated as equity instruments, avoiding interest-related tax obligations. Investors, however, must consider capital gains tax when the notes convert into equity.
To understand the implications of taxes for SAFE notes better, it is always recommended to seek legal counsel. UpCounsel has many valuable and free resources for startups, and can also help you connect with a startup attorney if you require professional advice.
Post-Money vs. Pre-Money Valuation
Valuation frameworks play a critical role in SAFE note agreements. Pre-money valuation calculates a company’s worth before a new investment, while post-money valuation includes the investment amount. These frameworks affect how ownership percentages are determined during equity conversion.
Investors & startups should both carefully review valuation terms in SAFE notes to align expectations with long-term growth strategies and return on investments.
How to Prevent SAFE Note Problems
While SAFE notes simplify the fundraising process, they come with potential risks that can create challenges for both startups and investors. To prevent problems, it’s essential to follow best practices during drafting and execution.
Best Practices for Drafting SAFE Notes
Clear communication is key when drafting SAFE notes. Startups should work with experienced legal counsel to ensure the terms are precise, transparent, and compliant with applicable laws. They should also include essential details, such as:
- Valuation caps
- Discount percentages
- Triggering events.
In addition to including these details, the SAFE notes should outline how these terms will impact ownership during conversion. Using standardized templates, such as Y Combinator’s SAFE note templates, can streamline the process while minimizing errors.
Common Pitfalls and How to Avoid Them
One of the most common pitfalls with SAFE notes is issuing multiple rounds with inconsistent terms, leading to complex ownership structures and investor dissatisfaction. Startups should model dilution scenarios for future funding rounds to anticipate how SAFE notes will impact ownership and voting rights. Investors, on the other hand, should verify that terms like valuation caps align with their expected return on investment.
Another issue is failing to define trigger events clearly. Misunderstandings about when and how SAFE notes convert can lead to disputes. Both parties should agree on specific conditions for conversion, such as equity rounds, acquisitions, or liquidation events, and document these thoroughly.
The KISS (Keep It Simple Security)
The KISS (Keep It Simple Security) is an alternative to SAFE notes, designed to provide flexibility while addressing some of the limitations of SAFE notes. Developed by 500 Startups, KISS agreements share similarities with SAFE notes but include additional investor protections.
Structure and Features of KISS Agreements
KISS agreements are available in two formats: debt-based and equity-based. The debt-based version accrues interest and includes a maturity date, similar to convertible notes. The equity-based version, on the other hand, functions more like SAFE notes by deferring equity conversion until a triggering event.
Both formats include provisions for valuation caps, discounts, and most-favored-nation (MFN) clauses, giving investors robust protections while maintaining simplicity. These agreements are standardized, making them easier to execute than traditional convertible notes.
SAFE Notes in Practice
SAFE notes have become a go-to tool for early-stage funding, particularly in tech-focused regions like Silicon Valley. Y Combinator’s widespread use of SAFE notes has influenced their adoption across industries, demonstrating their practicality and efficiency.
Things to Consider
Before using SAFE notes, startups and investors should evaluate key factors, including the impact on ownership, potential dilution, and alignment with long-term goals. While SAFE notes simplify early-stage funding, they may not suit every situation, particularly for companies seeking traditional equity structures or immediate returns.
Questions to Ask When Buying a Convertible Note or SAFE Note
Investing in SAFE notes or convertible notes requires careful evaluation to ensure your investment aligns with your goals and risk tolerance. Asking the right questions can clarify the terms, highlight potential risks, and help you make informed decisions. Below are some examples of questions you should ask.
- What Are the Valuation Cap and Discount Terms?
- What Is the Estimated Timeline for Conversion?
- Are There Multiple SAFE Note Rounds?
- What Are the Triggering Events?
- How Does This SAFE Note Compare to Other Funding Instruments?
Advice for Evaluating Funding Agreements
Thoroughly review the SAFE note’s terms, and don’t hesitate to seek professional advice. Consulting an experienced attorney or financial advisor ensures that the agreement aligns with your investment goals and minimizes risks. Additionally, ask for a pro forma cap table to visualize the potential dilution and ownership structure after conversion.
Get Started Writing SAFE Notes
If you’re a startup founder looking to raise funds or an investor evaluating SAFE notes, having professionally drafted agreements is essential. UpCounsel connects you with experienced attorneys who specialize in startup funding and can guide you through the process. You can explore tons of free, valuable resources for startups to get started on your investing or fundraising journey.
FAQs
1. How does a SAFE note work?A SAFE note provides funding in exchange for future equity, converting during a triggering event like an equity round or acquisition.
2. What is the main benefit of SAFE notes?SAFE notes simplify the fundraising process, offering startups flexibility and investors favorable conversion terms.
3. What are the risks of using SAFE notes?Risks include potential dilution for startups and delayed equity conversion for investors.
4. Are SAFE notes better than convertible notes?SAFE notes are simpler and lack debt characteristics, but convertible notes may offer more security for investors due to maturity dates.
5. How do valuation caps affect SAFE notes?Valuation caps set a maximum company valuation for conversion, ensuring investors receive favorable equity terms.