SAFE Note

How Do SAFE Notes Work?

The core mechanism of SAFE notes revolves around their conversion to equity upon specific triggering events, typically a priced equity round, company sale (i.e., strategic M&A), or initial public offering (IPO).

The simplicity inherent to SAFE notes accelerates the fundraising process, allowing startups to secure capital more efficiently and defer complex valuation discussions until a later stage.

The early-stage investor who contributed capital does not receive direct ownership in the startup post-investment. Instead, the shares are received on a later date, once the company raises its first “priced round,” which is based on a specific investment amount and agreed-upon valuation.

The SAFE note has four key features, in particular:

^{SAFE Financing Documents (Source: Y Combinator)}

What is the Valuation Cap in SAFE Note?

To mitigate the risk of an issuance of a SAFE note, most are structured with features such as a valuation cap or discount rate, ensuring favorable terms upon conversion, i.e., “downside protection”.

The absence of a fixed repayment schedule and obligation to issue interest periodically removes the burden of debt on startups, offering them the capacity to focus on growth and product development.

The valuation cap is a limit on how much a SAFE can be converted to equity ownership in the future.

Therefore, valuation cap represents the maximum price at which an investor can convert a SAFE to stock— a predetermined amount that “caps” the conversion price once shares are issued.

However, the financing structure implies that the early-stage investor assumes greater risk (and likelihood of losing their original contribution), since there is no guarantee of a return if the company fails to reach the stated triggering event.

From a regulatory perspective, SAFE notes are generally considered securities and must comply with relevant financial regulations. The U.S. Securities and Exchange Commission has provided stringent guidance on these instruments, emphasizing the importance of clear disclosure and investor protection.

The regulatory attention underscores the growing significance of SAFE notes in the startup ecosystem and the need for both companies and investors to understand the broad implications.

The proper legal and accounting advice (or diligence) is integral to navigate the complexities of SAFE notes and ensure compliance with applicable laws, per usual with financing.

The adaptations reflect the dynamic nature of startup financing and the ongoing efforts to balance the needs of founders, investors, and other stakeholders.

While SAFE notes offer numerous advantages, challenges and disputes can emerge as the cap table becomes more complex, such as when multiple notes are issued and misalignment between early and later investors.

However, the SAFE notes continued to evolve over time, with variations like the Post-Money SAFE introduced in 2018 to provide greater clarity on ownership percentages.

^{SAFE Note User Guide (Source: Y Combinator)}

What are the Characteristics of SAFE Notes?

What are the Benefits of SAFE Notes?

SAFE notes offer several notable benefits, including the following:

• No Interest or Maturity ➝ Unlike traditional loans, SAFE notes do not include interest payments (or a maturity date).
• Valuation Caps ➝ SAFE notes often include valuation caps, which limit the amount of equity that can be issued at a future date.
• Discounts ➝ SAFE notes normally include discounts, which reduce the conversion price of the note.
• Participation Rights ➝ SAFE notes may include participation rights, which allow the investor to participate in future rounds of financing.
• Simplicity ➝ SAFE notes are generally simpler and require less time to negotiate (and receive financing) relative to traditional equity or debt issuances.

What are the Risks of SAFE Notes?

SAFE notes carry potential disadvantages, including the following:

• Dilution of Equity Ownership ➝ One of the major risks associated with SAFE notes is the potential for significant dilution of the founders’ equity stake. Because SAFE notes convert to equity during a future priced round, the more SAFE notes a startup issues, the greater the dilution will be when they convert. The conversion can result in founders owning a much smaller percentage of their company than initially anticipated.
• Complex Computation ➝ If multiple SAFE notes are issued with different valuation caps and discounts, the calculation of equity distribution can become extremely complex, leading to unforeseen dilution levels for entrepreneurs and earlier investors.
• Valuation Cap Considerations ➝ The terms of SAFEs are clearly stated in the agreement, such as the conditions required for equity conversion. However, one must ensure that if a SAFE investor gets a valuation cap higher than the valuation of the next equity round, they do not effectively receive any discount on their investment (i.e., founder should renegotiate).
• Fewer Investor Protections and Rights ➝ Unlike traditional priced equity rounds, SAFE notes typically offer fewer protective provisions and rights for investors, such as voting rights, information rights, or anti-dilution protections. The lack of formal investor protections may deter some sophisticated or institutional investors from participating in SAFE note rounds.
• Complex Accounting ➝ The accounting treatment of SAFE notes can be complex, and there may be tax implications for both the company and investors during the conversion process.

What is a Trigger Event?

The trigger event refers to the contingency event that upon occurrence, causes the SAFE note to convert into equity.

The most common types of trigger event stated in a SAFE note agreement are as follows:

• Priced Equity Financing Round
• Exit Event (IPO or Acquisition)

The former is far more common than the latter, since startups usually raise capital via multiple rounds of financing before an exit event occurs.

The investment amount will convert into shares in the startup following a trigger event, adjusted per the discount. The conversion is treated as a liquidity event, with the SAFE investors receiving shares (or cash proceeds) based on the pre-negotiated terms.

In the case of a financing round, the SAFE will convert into the class of shares being issued in the round (e.g., Seed Preference Shares), and in an exit event, the SAFE will convert into ordinary shares.

SAFE Note (Y Combinator): Terms Explained

SAFE Note vs. Convertible Note: What is the Difference?

SAFE Notes and convertible notes are both financial instruments used in early-stage funding, but the two methods to raise capital carry different attributes in several key aspects:

• Interest and Maturity ➝ Convertible notes typically include interest payments and a maturity date, while SAFE notes do not.
• Valuation Adjustments ➝ SAFE notes do not include valuation adjustments, while convertible notes may include discounts or premiums based on the company’s valuation.
• Triggering Events ➝ SAFE notes are triggered by specific events (e.g., a priced equity round, company sale, or IPO), while convertible notes can be converted at any time.
• Ownership ➝ SAFE notes do not specify ownership percentages, while convertible notes may include detailed ownership terms.
• Regulatory Requirements ➝ SAFE notes must comply with relevant financial regulations, while convertible notes may have more flexibility in this regard.

The differences highlight the trade-offs between the two instruments, where SAFE notes offer simplicity and flexibility, but at the cost of less detailed ownership terms and potential challenges in cap table management.

In contrast, convertible notes provide more certainty and control, but may require more complex financial management and compliance with regulatory requirements.

SAFE notes and convertible notes do not necessitate the startup founder (or co-founders) and the investors contributing capital to agree upon the current valuation of the company, including the other terms that are part of the standard term sheet.

SAFE Notes vs. Equity Compensation: What is the Difference?

SAFE Notes and equity compensation (or financing) represent distinct approaches for early-stage startups to acquire resources and incentivize stakeholders.

While both methods contribute to a company’s growth, the mechanisms and implications of each differ significantly:

• Nature of Instrument ➝ SAFE Notes are a form of convertible security, while equity compensation involves direct issuance of company shares or options.
• Purpose ➝ SAFE Notes are used to raise capital from investors, while equity compensation is typically used to incentivize employees, advisors, or contractors.
• Conversion ➝ SAFE Notes convert to equity upon specific trigger events, while equity compensation grants immediate ownership or the right to purchase shares.
• Valuation Impact ➝ SAFE Notes can impact future valuations and cap tables, while equity compensation dilutes existing shareholders immediately.

SAFE Note Calculation Example

Suppose an early-stage AI startup is raising a $1 million seed round from venture investors using SAFE notes with a $10 million valuation cap and 20% discount rate.

One of the investors, an angel investor, contributes $500k via a SAFE note — for which, the terms of the SAFE note are as follows:

• Investment Amount = $500,000
• Valuation Cap = $10 million
• Discount Rate = 20.0%

Suppose twelve months later, or one-year after the seed funding, the startup raises a $6 million Series A round at a $20 million pre-money valuation.

The Series A represents a priced equity financing round, so the SAFE note converts into equity, per the terms of the agreement.

The ownership from the SAFE, Series A price per share is calculated as:

• Share Price = $20 million Pre-Money Valuation ÷ 10 million Pre-Money Shares Outstanding = $2.00 Per Share

With a 20% discount, investor’s share price is equal to $1.60 per share.

• Share Price = $2.00 x (1 – 20.0%) = $1.60 per share

However, due to the valuation cap of $10 million, Investor A’s effective share price is further adjusted:

• Share Price = $10 million Valuation Cap ÷ 10 million Pre-Money Shares Outstanding = $1.00 per share

Since $1.00 per share is lower than $1.60 per share, the angel investor’s cap price is $1.00 per share, wherein the $500k investment amount is converted to 500k shares.

After the Series A, the AI startup has a total of 13M shares outstanding.

• Total Shares Outstanding = 10 million Pre-Money Shares + 3 million New Series A Shares = 13 million

Since the angel investor owns 500k shares, the attributable ownership stake is 3.85% of the startup.

• Ownership Stake (%) = 500k shares ÷ 13 million total shares = 3.85%

Therefore, our hypothetical scenario illustrates that by using the SAFE with a $10 million valuation cap and 20% discount, the angel investor that contributed $500k toward a SAFE note managed to receive shares at better pricing compared to the Series A investors (and now owns 3.85% of the startup for the $500k investment).

The valuation cap and discount evidently benefited the investor relative to the Series A pricing, but the positive outcome was from the liquidity event that materialized.

In closing, the SAFE note provided the early-stage AI startup with the optionality to raise seed funding by granting the angel investor with future equity rights without the need for a premature valuation, from the perspective of the startup.