Kruze Consulting understands SAFE notes and how they can be used for startup funding. We can help you learn how SAFE notes affect your balance sheet and the relationship between SAFE notes and your taxes. Let’s take a look at this important funding option.
SAFE notes are a simple, easy and fast form of financing documents for startups, especially for angel and seed fund investors. The historical way that founders raised money is through convertible debt, but SAFE notes are a little bit more founder-friendly. They’re designed to be more quick, easy, and inexpensive. They are easy to document and generate smaller legal fees.
In addition to those benefits, SAFE notes have two major differences from convertible debt:
While SAFE notes don’t have a maturity date, they do have a valuation cap that’s negotiated between the investors and the founder. Essentially, the cap sets a limit on the price at which the notes convert to equity when the startup has another round of funding, providing an incentive for early investors, since they will get a much lower valuation and therefore a larger ownership share.
A common example would have a SAFE note being at a $5-10 million cap. And the next funding round, like the series A, may come in at a $20-25 million valuation. You can see there’s a really big valuation delta there, and the seed and angel investors who invested in that SAFE note got the benefit of that much lower valuation. Therefore they get more ownership for the money they put in because their valuation is so much lower. That’s a really big point: SAFE notes are effectively equity.
There are also instances where founders are able to negotiate uncapped rounds. These aren’t popular with investors because if the company’s valuation is increasing using the SAFE investors’ money, the investors don’t get rewarded. But some investors will do uncapped notes.
In recent years, there have been some extra provisions put in some SAFE notes, which basically say, “The investors get paid back first.” When SAFE notes first came out, they didn’t have that. That’s why we always thought of it as equity. If it has that provision, it starts becoming more like debt. It’s a fine distinction, but we typically book SAFE notes as equity, whereas convertible debt would be debt.
In general, remember that SAFE notes are a more friendly version of convertible debt. They’re very fast. They’re quick. They’re inexpensive to document. One caveat: You can get into a little bit of trouble if you start stacking SAFE notes because the interplay on dilution can get a little complicated. We typically recommend one or two rounds of SAFE notes and then do a conversion to preferred and common stock, and clean up your cap table. If you have questions on using SAFE notes, contact us.
While most SAFE notes have an implied valuation, in the form of the valuation cap, there is often a discount rate that can come into play if the company raises money below the valuation cap.
If the next round is done at below the cap, then the Seed investors usually get a discount of 15% to 20% for being early investors. But everyone is hoping the valuation is much higher for the next round.
For example, assume a company raises $3M on a $15M cap. Then, later, they raise their Series A round (this will be preferred stock with a stock price and valuation). If the pre-money valuation is only $10M, then it is below the SAFE note’s valuation cap. So the investors, instead of taking the $15M cap valuation, get to come in at $10M times one minus the discount.
So if it’s a 20% discount, their valuation will be $8M instead of the cap valuation of $15M.
The discount is basically an insurance policy for investors so that they get a little more if the valuation cap was too aggressive.
SAFE notes are classified as equity on the balance sheet until conversion – learn about how to account for SAFE notes.
A good acquisition is a happy moment for founders and investors. That’s the reason people invest in startups. But how does an acquisition affect SAFE notes?
A SAFE note is a security that is going to convert to stock at a future point, usually at a pre-negotiated price cap. Let’s look at an example. A person might invest in a SAFE note with a $10 million cap.
If the company is bought for $100 million, that’s great news. Provided there is no other money, the investor will get a 10X return on their investment. The SAFE note will convert to common equity and they get to participate in the upside of the acquisition.
But what if the company is acquired for a lower dollar amount? To extend the example, an investor may have a $2 million investment in a SAFE note with a $10 million cap. But the company was bought for $2 million. In that situation, the SAFE note will act like debt and the investor gets paid back first, and that’s true for the majority of SAFE notes. It mitigates losses for investors. Some investors may choose to share some of those funds with founders to encourage them to follow through with acquisition.
So as a quick rule of thumb, in a really great high outcome acquisition, the SAFE notes are going to convert to common at the negotiated convert prices, and investors are going to participate in the upside of the acquisition. With a downside acquisition, you’re going to get at least some of your money back.