For those of you entrepreneurs who are considering raising capital for your start-up, there is good news: you can now do it in a more cost and time-efficient way with the newly-introduced Simple Agreement for Future Equity (SAFE) note.
What is a SAFE note and how is it different to a Convertible Note?
The concept of SAFE notes was developed by Y Combinator in 2013 with the aim of simplifying the process of obtaining capital. Since its inception, SAFE notes have gained wide appeal in the startup market and in 2015 arrived in Australia.
The SAFE note is an overhaul of its traditional counterpart, the convertible note. The main change is the removal of the debt structure. Traditionally with the convertible note, capital injection is in the form of a debt, having interest payments and a maturity date. This posed as a hindrance to many entrepreneurs given that their business is already financially strained. As a hybrid security, this debt structure only transforms into equity when the maturity date expires or when a triggering event transpires. Examples include exit sales, IPO, funding rounds etc.
With the SAFE note, having an equity construct, capital is provided interest free and like the convertible note, this capital is only transformed into stocks by a triggering event. Since in this case, investors do not receive debt repayments, they usually seek to establish stronger discount rates and smaller valuation caps instead. This is not to say that valuation caps and discounts are not a feature of convertible notes, but that given these mechanisms are the only leverage for the SAFE investor, they are usually negotiated more rigorously.
Valuation Caps and Discounts Explained
You might be wondering, what are valuation caps and how do discounts work? This section would hopefully clarify those queries.
Looking from a holistic perspective, valuation caps and discounting are means of compensation for the initial investor who assumes the highest risk relative to later investors. These mechanisms allow initial investors to convert their capital to stocks at a cheaper stock price when the equity value of business rises.
Valuation caps are a means of hedging against dilution risk. Dilution risk stems from subsequent funding processes (e.g. series A), and is when the initial investor’s investment position is worth less due subsequent funding rounds. To mitigate this risk, a valuation cap is established to create a stock price ceiling for the investor especially for cases when the startup’s actual valuation exceeds the initial valuation.
For example, imagine setting up a note with an initial investor and he/she establishes a note cap of $2.5 million. However, after the series A stage, you get funded by another investor, and your startup becomes valued at $10 million. This triggers a capital-to-equity conversion event and your first investor has the right to convert his capital as though the company is valued at $2.5 million – that is, they will convert 4 times more cheaply as they would without the cap.
Initial note investors also have the option of converting their capital to equity at a discounted rate. The rates usually range from 15-25% and is established through negotiation.
Types of SAFE Notes
There are thus 4 types of SAFE notes:
- Safe: Cap, no Discount
- Safe: Discount, no Cap
- Safe: Cap and Discount
- Safe: MFN, no Cap, no Discount
On a final note, if you are considering a SAFE note, you should know that it is not without its setbacks. Whilst a SAFE note seems attractive given its simplicity, too much reliance on it would reduce your startup’s investment appeal for future investors given the strong leverage that initial investors have.
Are you interested in using a SAFE? The LawPath 700+ Lawyer Marketplace has a number of SAFE specialist lawyers. Contact LawPath to find out more.
Let us know what you think about SAFE notes and Convertible notes by tagging us at #lawpath or @lawpath.