Fundraising Deconstructed: The SAFE Note
-- by Jessie Gabriel
Whether you’ve launched a startup, invested in a startup, or launched a venture fund, chances are good you’re familiar with the SAFE note. Unfortunately, chances are almost as high that you’ve never felt like you fully understood the mechanics. When speaking to our clients about ways to structuring fundraising and SAFEs in particular, the most common response is: “Yes, I’ve heard of SAFEs. But if I’m being honest, I don’t really get how they work.” Of course you don’t! They’re confusing! Even to lawyers.
The purpose of this post is to go over the basics of these strange little instruments. If we’re lucky, by the time you’re done reading this post, you’ll be at least 50% less in the dark than you were when you started.
Where did SAFEs come from? The Simple Agreement for Future Equity (SAFE) was created in that OG accelerator, Y Combinator. As I understand it, the goal was to create a very simple document that would: (1) reduce the legal spend required to negotiate more detailed legal documents; and (2) be friendlier to startups than a standard convertible note. Voilà. The SAFE was born. As an aside, yes, the term SAFE note is redundant. At the same time, this is the common lingo. This post uses the terms SAFE and SAFE note interchangeably.
What is the general gist of a SAFE note? Before SAFE notes, there were two main options for raising startup capital: convertible notes and priced rounds. Priced rounds are tricky at the earliest stage because it’s impossible to put a hard valuation on a new company and the documentation and negotiation can be lengthy and expensive. Convertible notes were a lighter lift and allowed for greater valuation flexibility, but they are also debt instruments. This means that, if a startup raises money through a convertible note, they may ultimately have to pay it back and usually within a couple of years. That’s not feasible for a lot of startups. The SAFE note operates like a convertible note but without the obligation to repay. The investor invests an amount now. in order to have the right to convert that investment into company shares down the line (when the company raises a priced round or has an exit (let’s call these “Conversion Events”)).
What is a valuation cap? There are two terms in SAFE notes that are adjustable: the valuation cap and the discount. Let's say the valuation cap is $10,000,000. That means that, no matter how the company is valued when it experiences a Conversion Event, your shares will convert as if the company were valued at no more than $10,000,000. The conversion price for you will be equal to $10,000,000 divided by the company capitalization (the number of shares of company stock). If the company takes off and is valued at $20,000,000 in their next round, then you are going to get a roughly 50% discount relative to the new investors coming in.
What’s the difference between a pre-money and post-money valuation cap? If the SAFE has a pre-money valuation cap, that means that cap does not take into consideration the money raised under the SAFE. If the SAFE has a post-money valuation cap, that cap includes the new money. To illustrate, let's say the company above is raising $2,000,000. If the valuation cap is pre-money, it doesn’t matter how much of that $2,000,000 they raise. No matter what, your cap is $10,000,000. If, on the other hand, the valuation cap is post-money, if the company raises $2,000,000, the effective cap is $8,000,000. If the company only raises $1,000,000, the effective cap is $9,000,000.
What is the discount rate? The discount rate provides another avenue to ensure SAFE investors get a benefit from investing early. Let’s say the company above is valued at $8,000,000 at the time of the Conversion Event. Okay, then there’s no benefit for you in the valuation cap. Instead, you get the benefit of the discount rate. The discount rate is most commonly 80%. Here that would mean that, whatever price the new investors pay, you will only pay 80% of that price (in other words, your $100,000 will be divided by the {[new money price] * 80%} to arrive at the number of shares you receive. Note that, in this scenario, the “Discount Rate” (as defined in the SAFE) is 80% (not 20%). Meaning your conversion price will be the new money price * 80%. You are getting a 20% discount, but the Discount Rate is 80%. See earlier comment re SAFE notes being confusing.
If I invest $100,000 on a SAFE note, how many shares will I get? Well, it depends. It depends primarily on three factors: (1) the valuation cap; (2) the discount rate; and (3) the price of the shares at the time of the Conversion Event. As a SAFE investor, you get the benefit of the better of the price based on the valuation cap and discount rate. At the same time, and I think this is where the document loses a lot of people, you still won’t know how many shares you have until the Conversion Event takes place.
Then how can I tell how much of the company I own? Well, until the SAFE converts you don't own anything. The only way to get a sense of your ownership after the Conversion Event is to run a model that illustrates different conversion scenarios. This is something we put together for our startup clients when they are raising on a SAFE note. This way you get to see what your cap table looks like depending on different caps, discounts, and Conversion Event scenarios. Otherwise, you risk falling into the trap of picking valuation caps and discounts at random and then being surprised how much ownership you've given away when you reach a Conversion Event. Chances are good you know at least one founder this has happened to.
What happens if the company goes under before my SAFE converts? Herein lies the risk of startup investing. If the company goes under, you are technically entitled to receive your money back. But the reality is that most startups that go under do so because they don’t have any money in the bank and no real assets. You’ve heard it a million times: startup investing is very risky.
There is a lot more to say here. For documents that appear so short and sweet, they are surprisingly complex. But hopefully the notes above will give you more confidence the next time someone starts talking to you about SAFE notes. And if you’re still lacking confidence, just ask! If someone judges you for not fully understanding these documents, chances are that person doesn’t understand them either.
