SAFE notes: Equity or debt instrument?
In 2013, the Silicon Valley accelerator Y Combinator created a new standardized legal document as an alternative to convertible notes that combines the best characteristics of equity and debt. A SAFE, or Simple Agreement for Future Equity, has no maturity date, no interest rate, and no threat of insolvency; therefore, unlike a convertible note, a SAFE is not a debt instrument.
Before the existence of this hybrid tool, most startups were offered equity or loans (usually in the form of promissory notes) for investment capital. Now, using a SAFE and its alternatives — for example, 500 Startups, another startup accelerator, has created its own version: the KISS, or Keep it Simple Security — the investor is able to buy the right to purchase equity if and when the company conducts an equity round of financing.
Thus, the only event that forces the company to return the investment (converting it into equity) is in the event of sale or a priced equity round. This eliminates one of the main problems inherent to debt: the need to service it with ongoing cash payments.
Note that, even if the main intention of the SAFE is to simplify the agreement for companies and investors, a SAFE is subject to negotiations and one to another can vary in many aspects depending on the interests of management and potential investors. As a result, despite the name SAFE, they are not always that simple, and not always “for future debt.”
No maturity date: There is no official maturity date, so there is no specific point when the investment has to be repaid. The SAFE is designed to convert the investment amount when the company raises equity financing, upon sale of the company, an IPO or a dissolution (when the invested amount would be distributed first to the SAFE investors). Until a conversion event occurs, the SAFE remains outstanding.
No interest rate: The investors obtain an interest rate, and in return, they have the right to convert their SAFE into equity at a discounted price in the subsequent financing according to the discount and/or valuation cap. A most favored nation (MNF) clause can be included; that is, if better terms are given to future investors, they are automatically inherited by the SAFE investors.
Who is this SAFE for — and why?
A SAFE can be an effective financing option in the early-stage of the startup. The note is ideal for entrepreneurs in early-stage funding rounds because of the low transaction cost, reduced time spent negotiating and lower legal fees. In addition, it’s favorable because, at this point, neither the founders nor investors know the company’s market valuation or what ownership percentage of the company they are giving away. Lastly, generating cash the first years of operation of the company can be difficult.
However, the uncertainty that a conversion event will occur makes this instrument not that “safe” of a tool for the early stage investors. Early-stage investors often feel that they are taking all the risk for companies that are simply a team or concept. The younger the startup, the more risk involved in the investment.
A SAFE note helps investors provide capital to certain investments while also ensuring that they incur some upside if the company progresses. From the founder perspective, there are many reasons to adopt a SAFE as a debt instrument: it’s low-risk, pro-company, easy to negotiate and fast to cash out. However, an investor has to have the best interests of the company in mind, so if the company reach its highest potential the SAFE can also be seen as pro-investor.
Earnest Sweat serves as an Investment Manager at a corporate venture capital group. Earnest has a combined ten years of experience in the real estate and technology industries. He currently focuses on the technical and business model due diligence of investment opportunities. Earnest gained portfolio management, venture deal analysis, and financial modeling expertise in stints as an investor-in-residence at Backstage Capital. He is an alum of Columbia University and the Kellogg School of Management.
Carlota Sáenz Guillén contributed to this article. Carlota is a lawyer in Silicon Valley specializing in startup law and venture capital. She earned her JD in University Pompeu Fabra (Barcelona) and has a Master of Laws (LLM) from Berkeley School of Law.