SAFE Notes: Everything You Need to Know
SAFE (simple agreement for future equity) notes are a simpler alternative to convertible notes, and allow startups to structure seed investments without interest rates or maturity dates.18 min read
What Are SAFE Notes?
SAFE (simple agreement for future equity) notes are a simpler alternative to convertible notes. They were created in 2013 by Y Combinator, a Silicon Valley accelerator, and allow startups to structure seed investments without interest rates or maturity dates. SAFEs are short five-page documents, and the valuation caps are the only negotiable detail.
A SAFE note is a convertible security that, like an option or warrant, allows the investor to buy shares in a future priced round. It addresses many of the drawbacks and challenges posed by convertible notes and can be an equitable option for investors and founders. Startups may prefer SAFE notes because, unlike convertible notes, they are not debt and therefore do not accrue interest.
Seed Investments: General Terms
Both convertible notes and SAFE notes are convertible securities, which means they can eventually be converted to equity. The following are some general terms and considerations to be aware of.
Discount and Valuation Caps
Convertible securities typically include a discount that can be applied to the future valuation when it's time to convert. A valuation cap sets the highest price that can be used to set the conversion price. At the time of conversion, the investor can take advantage of either the discount or the valuation cap — whichever is more favorable.
SAFEs can include a discount, a valuation cap, both, or neither. However, it is not common for either to be absent, as that would discourage investors.
Early Exit Payback
Early exit payback means that notes can be paid out to the buyer if an acquisition or change of control should occur prior to the regularly expected conversion.
Often, if there is a change of control, convertible note templates will give a 2x payout option as well as an equity conversion. Alternatively, if they stay with the acquisition, they can have a 1x payout or equity according to the valuation cap.
Sometimes, a startup is a limited liability company, not a C-corporation. A limited liability company can use a convertible note, since that kind of note is a debt instrument. On the other hand, SAFE notes require C-Corp status because the investment is noted on a capitalization table just like stock options. Some people do find ways to use SAFE notes with an LLC, but it is not simple. A reputable lawyer at UpCounsel can help you decide which option is appropriate for you.
It is possible for a note to change into equity during a future round of financing. For a convertible note, a minimum amount must be raised in the round before it can convert. However, SAFE notes can convert with any dollar amount in a preferred cycle. Going without a qualifying transaction obligation can help, since this would prohibit a conversion to real equity.
Term (Maturity Date)
Since SAFE notes are not a debt instrument, there is no maturity or end date. An end date can force a conversion to equity, as well as provide a right to equity conversion via the valuation cap. With SAFE notes, investors could be waiting endlessly for maturity, even once the business is turning a profit.
SAFE notes also have no interest rates. Even with convertible notes, interest is rarely negotiated. However, even an exceptionally low interest rate adds up over time when pressed into a conversion formula, so it's advantageous to investers to include an interest rate in a convertible note.
Four Types of SAFE notes
- Cap, No Discount
- Discount, No Cap
- Cap and Discount
- MFN, No Cap, No Discount
Benefits of Using SAFE Notes
Both SAFE notes and convertible notes are good options, and there are good reasons to use either. When seeking seed money, it's typically best to choose the option that is most popular in your community, so that investors will feel comfortable.
To decide whether SAFE notes are for you, take some time to weigh the pros and cons. Benefits of SAFE notes include the following:
- Simplicity. A SAFE note is simpler than a convertible note. It has no end date or interest, and it is only a five-page document. You may even be able to understand and draft one without a lawyer's help. It will be straightforward, with perks and downsides that are clear.
- Less to negotiate. Unlike other investments, SAFE notes do not require much negotiation. Sometimes valuation caps are talked about, but that is all.
- Accounting. Like other convertible securities, SAFE notes end up on a company's capitalization table.
- Similar provisions. SAFE notes still make provision for early exits, change of control, or even dissolution of the company. There are provisions for investors, such as discounts and valuation caps.
- Conversion to equity. Investors can change their investment to equity later. The date of conversion is not predetermined, but it can happen when an equity round is raised and preferred shares are distributed.
- Flexibility for startups. The lack of pre-defined terms and a maturity date gives the startup total freedom, with no specific destination or expectation.
- Proportional benefits. When SAFE notes do convert, you may be entitled to better benefits in proportion to your original investment. They can offer preferred stock, called "shadow" or "sub-series" stock. This can be a better deal than convertible notes, but it can also make for a more complicated mix of shares. (Watch out for legal costs during equity rounds.)
Drawbacks of Using SAFE Notes
Some people recommend convertible notes instead of SAFE notes and believe that SAFE notes are not as simple or inexpensive as they appear. For example, there could be an instance in which after SAFE note is signed and a valuation cap discount is arranged, another investor offers a larger cap and requests that the SAFEs convert to a higher cap.
Investors and entrepreneurs may be wary of SAFE notes for the following reasons:
- Risk to investors. SAFE notes are not an official debt instrument, which means there is a chance they will never convert to equity, nor is repayment required.
- Incorporation requirement. A company must be incorporated to offer SAFE notes, and many startups are LLCs. That means a company will have go through the incorporation process before being able to issue SAFE notes, which may require the services of an attorney.
- Lack of familiarity. SAFE notes are relatively new, which means that both lawyers and investors have less experience with them. Convertible notes are more established and may be more attractive to investors.
- Fair valuation expenses. SAFE notes may trigger the need for a fair valuation (409a). A company may need to allocate funds for professional services, leaving less available for product development.
- Some people say that SAFE notes appear simple, but they are not. The document is five or six pages long, which is not so short. Other people feel that the sections with legal language are challenging to comprehend, and that it is close to, if not as difficult, as any other legal document.
- Distribution of dividends. Because of a loophole, dividends do not have to be paid to SAFE note holders the way they are paid to common shareholders. However, since the real purpose of a SAFE note is not to be repaid but to gain equity, investors may be comfortable with this arrangement.
- Lower returns. Accruing no interest on a short-term investment is not a big deal. However, if you hold an investment for over a year, it could make a huge difference. Accrued interest gives note holders a greater return on their investment and creates an incentive for a company to close an equity round.
- No minimum requirement. With SAFEs, there is no minimum requirement for an equity round to go into conversion. However, a minimum can actually be helpful because it lends the round legitimacy and value. It means that a SAFE note can be re-adjusted on a whim, and a smaller investor can negotiate a better deal and compete.
- Less favorable variations. Two of the four types of SAFE notes do not offer a discount, and two don't give a valuation cap. Those that have both — which puts the investor and founder on the same footing — require more negotiation.
Things to Consider
If you want to try SAFE notes, think about focusing on the priced equity rounds rather than the notes. A simple seed equity purchase does not cost so much anymore. It can be done for under $5,000 in a few days.
Uncapped SAFE Notes
- Notes should not be issued without the founder's understanding of their value.
- It is debatable whether anyone actually raises money with uncapped safes. Founders tend to use SAFE notes with caps.
- Note that five hundred startups have applied to raise funds on SeedInvest but have had to turn down deals with uncapped SAFE notes.
- Uncapped notes are becoming increasingly uncommon, perhaps because founders want to know their values.
Capped SAFE Notes
- Make the first convertible or SAFE note have a low cap on the amount sold, such as $1mm or $2mm — something reasonable.
- Don't do many rounds of notes with many different limits on them. That is too risky.
- Founders should have lawyers who note to them and to their investors a pro-forma cap at the closing of the note. This shows exactly how much of the company everyone will own if the note converted immediately at various price points. It can be updated every time a note is given.
- Consider doing an equity deal at 5m. (The point of notes coming into practice was to avoid the valuation dispute in the first place. The discount will mean something when the priced round is lower than the cap—a down round. If that happens, everyone will miss out.)
- Many startups are raising notes with 5 million caps but could get 3-4 pre-money. If the cap is the same as what you might earn otherwise, it is sometimes wise to price it out.
- Consider a note that is uncapped yet has a discount in the next round.
- Try to work with priced rounds.
- It would be great if your notes were structured as a cap being a minimum percent of its equity, not of the value.
- Raising common stock doesn't trigger a conversion for a safe investor, so entrepreneurs in need of some extra cash could do a "friends and family round" and avoid the conversion trigger, if there is a need to bridge.
SAFE Notes and Taxes
Investors should contemplate the relationship between the SAFE notes they purchase and the annual tax they will pay. An experienced accountant or litigator can advise on the ins and outs of this, but generally speaking, an investor will have a specific tax holding period.
For a convertible note, that period will begin with its purchase. Upon the transformation of the note, the holding period will be retroactive, dating back to the time it had been issued. For SAFE notes, the process is similar, except that SAFE note holding periods will initiate once the note is used; that is, when it is ultimately converted into equity.
Such a holding period for a SAFE note is not a bad thing. Even with that wait, the holding period is longer than a single year, from the conversion to the first equity round. There's no advantage to holding for more than a year, so the investor will not be reprimanded or lose out in any way.
Can SAFE Notes Negatively Affect Your Taxes?
If there is a non-cash sale of the company in which you invested or a sale that happens less than a year after you invested, it is possible that you might lose out. (This is also true if you have a convertible note.)
Some investors gaining seed money will aim for a five-year holdout for their notes, since this may help them merit the Small Business Stock Gains Exclusion under Section 1202 of the U.S. tax code. The IRS has yet to clarify how it will work, but as of now, it seems it will be very much like a warrant sale.
SAFE Notes and Valuation
As SAFE notes enter into the market, the market itself is affected in a way that differs from the potential impact of convertible notes. SAFE notes do not offer interest rates, maturity dates, or default exit dates, as previously mentioned. Some people may wish to earn compensation for missing out on these aspects. A higher conversion discount may be warranted, or a lower conversion cap.
The most important aspect to keep in mind, regardless of whether you're an investor or company, is that it is worth it to bargain when it comes to SAFE notes. Since the structure of the SAFE note (no interest, no end date) is less flexible than that of a convertible note, investors should try requesting a lower cap or higher discount.
Given the newness of these products, such suggestions can be done rather explicitly. The general cap and discounts given can and should be affected by the bigger picture of gains/losses and be relative to the perks found in convertible notes.
Why Are SAFE Notes Not As Popular As They Could Be?
Given the counter-option of the convertible note, some investors do not feel that they benefit from SAFE notes. Convertible notes, which are more established and conventional sometimes seem like a better choice. With that being said, many investors do not seek interest or end dates, so they may prefer SAFE notes after all.
First, since they seek equity as the end product, other investors may view a SAFE note as having no room to grow beyond what it offers. Secondly, these investors look at early stages to make a choice regarding fixed income benefits. However, SAFE notes fall midway in this category, with some risk and only some foreseeable gain.
As for convertible notes, it's hoped that they will transform prior to their end dates. They were once referred to as bridge notes. This term reveals the hope that the investment would grow dramatically prior to the final date. Despite this, investors have tended to hold them for longer periods than expected.
Convertible notes that default are few and far between. Most of the time, convertible notes don't have a post-default rate of interest, nor any other disadvantage. It is also possible that convertible notes don't fall into default anyway — because by their terms, they do not amortize or pay interest until they have reached the end date or conversion. They cannot be claimed via a payment default.
Lastly, it is clear that startups are setting their SAFE note prices low. This may be the result of not requesting favors or bargains: They feel they can offer the notes at a lower price. There often is a market discount that surrounds such notes, as well as a conversion cap, so this is not unexpected. As these aspects run with market norms, the investors tend to be agreeable to them.
History of Convertible Notes and SAFE Notes
Previously, seed and angel investments were accomplished with equity securities. In the early 2000s, convertible debts began, and they became quite popular. In August 2010, there was a tweet by Paul Graham, in which he claimed that these notes "won," since all investments done recently on his YC batch were convertibles.
Some people were not happy with convertible notes, despite their popularity. SAFE notes were developed to take over convertible notes, hoping to offer an easier process.
USV has done many convertible and SAFE notes, and a dozen or more exist in seed and angel rounds. However, some people find that neither convertible nor SAFE notes are best for founders. There are many reasons for this:
- Valuation and dilution is put off to a future time, and some people feel that this should not be deferred.
- They dismiss and confuse the value of the dilution that the founder asserts. Some investors approve of this as their strategy, but some don't, as they feel that founders have a right to know what they will own.
- SAFE notes can build and then implode, not being worth much at time's end for the founder when a pricing round occurs. (It is recommended that they don't do more than one at a time.)
- Founders must make decisions regarding ownership. If they act too soon, they might not be able to act again later because, at that point, their company could be worth less. Note holders blame the founder, but it's not always their fault.
- Sometimes, a startup survives a few years and is self-sufficient, but then collapses, and no one makes what they expected in the end. Some people feel it's not fair to allow young companies to cover their expenses in irresponsible ways, with methods that don't add up for themselves or the note purchasers.
- Other people feel that convertible notes are a problem if they are poorly structured, such as in the case of uncapped SAFE notes with no deadline date, discount, or interest.
- People feel that SAFE notes in particular do not reward investors for their risk and that investors may lose out. It could end poorly even after many years, and the original investors may end up with little.
SAFE Notes Versus Convertible Notes
SAFE notes are sold at the earlier stages of a company's development, when founders are seeking funds even from family and friends. The SAFE note simplifies the seeking of funds and reverts to the bare minimum requirements of investing.
Many people believe in the importance of having investors and founders meet in the middle in order for negotiations to work together for a greater good. All tools must be safe and productive on both ends so that investors can continue to invest and developers can create.
The SAFE note was created to make transactions quick and inexpensive. However, as you can see, there are problems with the SAFE note: while it's a quick deal, flexibility and future negotiation is lost. Therefore, it is worth considering its competitor, the convertible note.
Similarities Between Convertible Notes and SAFE notes
- SAFE notes and convertible notes can both offer a discount on an upcoming round, or a current round in the cause of convertible notes. There's no big difference in this case.
- Depending on your negotiating skills and your company's traction, you can get a SAFE or convertible note without a valuation cap.
- If you're looking for an early exit, convertible notes and SAFE notes both offer similar payout mechanisms in the event of a change in control (acquisition/IPO). The SAFE note is written to give the investor the choice of a 1x payout or conversion into equity at the cap amount to participate in the buyout.
- There are typically 2x payout provisions in a convertible debt agreement, which can still be written into SAFE agreements. Both options have seed investment advantages in this category.
- Both options also include the ability to get out early (another term for this is "change of control"), financial perks like the discount, and protections like valuation caps.
- They both transform into equity in a future priced round.
- Both have value maxims, savings, and most-favored-nations.
Why Convertible Notes May Be Better Than SAFE notes
- SAFE notes and convertible notes can both convert to equity, but a convertible note permits you to change your current round of stock or your future financial situation.
- Convertible notes apply when a "qualifying transaction takes place." This means that you can transfer them once an agreed-upon minimum amount is made or on a mutually agreed-upon date. On the other hand, SAFE notes can transform when any number of investments are accrued. Therefore, there isn't much control given to the entrepreneur with SAFE notes.
- Convertible debt can carry a simple interest rate ranging from 2 to 8 percent (most falling around 5 percent).
- Convertible notes have a maturity date, and this can create opportunities when the maturity date comes to pass. Once the maturity is reached, an entrepreneur has two choices: Pay back the principle plus interest (if the company has enough money to do that), or convert the debt into equity.
- Convertible notes have convertible security, discounts, valuation caps, and early exit payback 2x.
- The company type can be an LLC or C-corp.
- They are generally known and recognized. They are also fast and inexpensive to create through the company's lawyers.
- Startups can receive capital without a complicated equity round.
- Interest rates provide incentive for companies to raise rounds.
- The conversion is simple, with a valuation cap and discount.
- Convertibles sit at the top of the cap table but are flexible ("unsecured"), meaning investors can't foreclose on a company's assets.
- As an investor, you can change the note to equity if the startup changes power or is acquired. Nothing can get in the way of you opting to do so.
- If an investor opts for a convertible note instead, that means he has an end date in mind, which helps make things clear in the future. Interest does accrue, and this helps raise value on the initial investment.
Some people believe that convertible notes are best for investors and companies alike. It has been said that the SAFE note tries too hard to be easy, but convertibles are simply fairer.
If You Want an Option Instead of SAFE Notes
If people cannot understand the math of safe slips, then an equity deal might be best for them. A pre-money valuation can also be considered as a better choice.
Ask yourself: Should I raise equity with a full ratchet anti-dilution, or with broad-based weighted average anti-dilution? If you go with a broad-based weighted average, then do a priced round and not a note. If you do venture for a capped note, consider doing it in equity instead.
So What's the Best Option for Seed Investment?
From an entrepreneur's perspective, when weighing these variables, some people may claim that the SAFE note is the most advantageous instrument for raising a seed investment. Why? Because it doesn't require a maturity date, interest rate, or conversion (if you can hold out from raising a preferred series round). SAFE notes are a fantastic tool for entrepreneurs to consider when they're looking to raise their initial rounds of seed investment.
Convertible notes may be preferred to SAFE notes because they're a known commodity. The 10,000 types of convertible documents and warrants make them more nuanced and convoluted than Orrick, Fenwick, WSGR, and other series-seed equity documents. Every company that is looking for seed-round investment has different needs, so many factors should be considered when making a sound choice for you. If you need help deciding, contact one of UpCounsel's leading lawyers to go over the material with you.
SAFE notes may appear easier and more convenient for startups, but they have often been miscalculated. Even though SAFE notes have had some success, they are generally viewed as lacking the most common protective features of seed investment — namely, an end date and a guarantee of equity conversion.
The West Coast, therefore, has brought a newer and better version: the KISS (Keep It Simple Security). KISSes attempt to merge the straightforward aspect of SAFE notes with the protective mechanisms of its father, the convertible note.
Capital investors gain from the equity they turn over, and that is what they expect from seed investments they accrue. The Y Combinator created SAFEs to counteract the financing structure of the convertible and develop something more equity-based. Unfortunately, this backfired.
SAFE notes seem like good deals to startups and investors because they aren't recorded as debt, they save time and money with regards to negotiation, and they still include valuation caps and discounts. However, they do not carry interest, do they change to stocks at a specific time, and cannot be declared when in default. They lack key protections for investors, especially if equity is not raised.
KISS combines the best parts of SAFE notes with a more investor-friendly approach, much like convertible notes.
Pros of Using KISS
- KISSes have downside protections that are common in convertibles but not found in safes.
- KISSes offer interest at a transparent rate, and there is an end date. At the time of the end date, the amount can be converted with interest to a stock in the company.
- Additional privileges may be given, according to circumstance and investor.
- Investors have investment rights and can address ongoing company financial issues.
Kinds of KISSes
There are two kinds of KISSes. One is more similar to a convertible, while the other has an equity structure, similar to SAFE notes. The only difference is that the one that prioritizes equity has no interest. It's a balance between SAFE and convertible notes.
KISSes are still not perfect. For some reason, despite similarities and attempted developments, KISSes have not become more popular than SAFEs or convertibles. SAFE notes were created to simplify the convertible note, and thereby improve it. The KISS attempted to strike a balance between the two. However, it ended up being so similar to the convertible that it suffered from the same problems.
Given their complexity (compared to SAFE notes), KISSes require more discussion and negotiation, more legal fees, and more time. The usual debt formulations of interest and conversion are not unique, and they don't always take into account the hopes of startup companies. Those people must spend a great deal of time with the administrative components that the SAFE note sought to avoid. It all seems like a terrible waste of time and money.
The KISS may not be a winner, and it may not even be better than the SAFE or convertible note, but at least it's another option. Seed money is necessary for startups to flourish. SAFEs, KISSes, convertible notes, and even basic seed money financing are all helpful. The search for the best arrangement for investors and founders alike will go on.
The goal of such notes is to make capital increases simpler, less pricey, and more expedient. Hopefully, the outcome is to empower investors with choice and founders with the ability to employ more people and grow companies.
Final Questions Regarding SAFE notes
If you are an investor and you found this article relevant, consider these questions regarding SAFE notes and convertibles before moving forward.
As an investor, the most important reward for you is winning equity. Interest will offer some benefit, but growth for the company and for yourself is important. A convertible or SAFE note can guide you and help startups bring an equity round at a higher valuation.
However, when you invest in a startup, you should be credited for the risk that you take. Make sure you are protected. That is why SAFE notes should be looked upon with some skepticism.
- It is true that discounts are given on SAFE notes, but is this amount truly sufficient, given that a great sum was invested in the first place at the risk of a loss? Further, if the worth goes down in a year, the value invested will fall far more than the discount could make up for. Also, it is very likely that the price of the investment will fall and not go up again.
- Is it truly fair to buy into a convertible debt or SAFE note without a cap? When persons fund a startup, a cap is expected. There is a legitimate concern over dilution over time. As notes shift in value, everyone could lose out due to lower or higher conversions.
- Convertible notes can have multiple liquidation methods. If you buy 10 percent of a company worth $500 million that has been diluted as new investors come, it could have a $1.5 million liquidation. This is a 3x liquidation preference in disguise. Notes should be adjusted to only 1x the liquidation preference.
Questions to Ask When Buying a Convertible Note or SAFE note
- When the note matures, what will be the exact price?
- If the company is bought, what will happen to my investment? If you can agree on the multiple of your investment that you'll be left with, try to do so.
- Try to get a convertible with a specific price, rather than with a cap, so you agree on a maximum but also a minimum price. Determine the actual price, and opt for a secure approach.
Get Started Writing SAFE notes
The regulations in place for acquiring SAFE notes are equitable and reasonable to both parties: to the investor and the founder. Often, a few revisions are needed, so it is always recommended to seek legal counsel when embarking on an investment. UpCounsel has experienced enterprise lawyers who can help you with this.
You can post your legal need on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Stripe, and Twilio.