Early-stage companies that need to raise the first round of capital must select the smartest instrument to grow their business. The two most common are SAFE Notes which is a simple agreement for future equity and Convertible Notes or a form of debt that can convert to equity.
SAFEs have become the preferred instrument in Silicon Valley, which is indisputably the world capital of venture capitalist and start up. A SAFE Note works as a warrant since it’s an option to purchase equity later based on the terms the agreement defined. In 2013, Y Combinator, the Silicon Valley Accelerator developed SAFEs to provide a streamlined, cost effective and lean process that protected entrepreneurs and the investors. It became the most preferred instrument replacing the more traditional convertible note, a debt instrument that allow entrepreneurs to raise capital with a promise to convert into equity at the note’ maturity. SAFE NOTES emerged as the low cost go to instrument to first time entrepreneurs, angel investors as well as VCs investors.
SAFEs have two distinguinshing factors, a Valuation Cap and/or a Discount. Here below we break them down:
- Valuation Cap – More commonly known as cap, it’s the maximum valuation that the investor will be valued at if the SAFE already converts to equity. The lower the valuation cap, the less interesting the deal is for founders because investors can convert their notes into more equity in the company.
- Discount – This refers to the discount that the venture capital firm, angel, or startup could get at the next financing round’s valuation. The discount rate of a SAFE describes the ‘discount’ that investors will receive on the priced round when it converts. The higher the discount, the less advantageous the deal is for founders because investors receive more equity.
SAFE notes are five-page documents that have no interest or end date. They’re simpler than convertible notes. They’ll usually be straightforward, that’s why anyone may be able to understand and even draft one without help from a costly lawyer. Also, SAFE notes free up the time of investors while helping the company move at a faster rate with less bureaucracy. That’s because investors aren’t required to sign off on the decisions of the company or attend shareholder meetings. For early-stage companies, it’s going to be a big advantage, especially for those with limited resources to succeed.
Startups and investors use SAFEs because they are lightweight, standardized, and straightforward resulting in quicker execution times. Typically, startups can close a round of funding in less than a month with SAFEs, as opposed to months with traditional term sheets. SAFEs protect and align the interests of both the startup and the investors, as they only convert once certain milestones, such as valuation, or strike price is hit.
Silicon Valley is the most prominent startup ecosystem in the world, and it has chosen SAFE notes as the de facto documents to be utilized for early-stage startup investment since they’re cheaper to execute, more streamlined, and easier to understand than other options.
What’s the difference between SAFEs and Convertible Notes: SAFEs and Convertible notes are both convertible financing options. However, unlike convertible notes, SAFEs do not:
- Mature. SAFEs do not mature, as such, founders do not need to prematurely raise a priced equity round.
- Accrue Interest. SAFEs do not accrue interest during the period leading up to or following their conversion into equity.
What about the valuation? Determining your startup valuation is challenging as an early-stage entrepreneur you have very low revenues, and a lot of intangible assets that you are seeking to price. In other words, entrepreneurs should calculate the value of ideas, know-hows, technology (when applicable), market size target, and human potential of the team. Seek to maximize your valuation but be reasonable and think of future fund-raising rounds where if you don’t hit market growth targets, you may be forced to raise funds at a lower valuation than the previous round. Also keep in mind that to convince an investor your valuation (which in early-stage companies is only done by the entrepreneurs), it needs to be reasonable based on some back of the envelope calculations.
Conclusion: It is important to remember that SAFEs are not debt, which means that the startup does not have to make payments and cannot default, because it’s not a loan. Hence the name SAFE. If you are a startup founder, you should take advantage of SAFEs as this will give you the flexibility and the protection that are key for risk takers as early-stage companies.