A Simple Agreement for Future Equity (or “SAFE Note”) is a relatively new form of financial instrument used by start-ups to raise working capital. SAFE Notes have developed as an alternative to Convertible Notes or direct equity fundraising. SAFE Notes have become popular in Australia over the last 5 years with seed stage start-ups because they are not a form of debt and are much simpler and quicker to negotiate than traditional forms of financing.

What is a SAFE Note?

A SAFE Note is an agreement between the start-up and investor whereby the start-up raises funds from investors in return for shares in the company when a specific milestone has been reached, such as an equity fundraising round, subject to the terms and conditions set out in the SAFE Note.

SAFE Notes are similar to Convertible Notes as both convert into shares in a future equity fundraising round, and both have a valuation cap and discounts.  At the time of conversion, the investor can take advantage of either the discount or the valuation cap — whichever is more favourable to the investor.

However, there are some key differences, such as:

• SAFE Notes are a convertible security whereas a Convertible Note is a form of debt;
• SAFE Notes do not have a maturity date whereas Convertible Notes do; and
• SAFE Notes do not accrue interest, unlike Convertible Notes.

How does a SAFE Note work? 

By raising working capital using a SAFE Note, there is no requirement for founders and investors to value a company at the time an investment is made. The benefit of this approach is that can be difficult to determine the value of a start-up (especially, seed stage start-ups).

The investor with a SAFE Note will be issued with shares in the company when the next equity fundraising round occurs. The investor will be issued the number of shares in the company based on the amount they invested in the company and the discounted price applied to the valuation of the start-up at the time of the equity fundraising round.

What are key features of a SAFE Note

SAFE Notes contain key features that explain how the Note eventually converts into shares in a company, which are as follows:

• Discount– investors with a SAFE Note are usually offered a discount on the market value for shares in a company at the next equity fundraising round. Discount rates range from 2 per cent to 30 per cent on the market price for the shares.
• Valuation cap– is a feature of a SAFE Note that establishes a maximum price at which the investment amount will convert to shares in a company. The lower the valuation cap, the more equity the investor will acquire in the company at the next equity fundraising round. Without a valuation cap or a discount price, the SAFE Note converts into shares in the company at market price at the next equity fundraising round.
• Liquidation rights – a SAFE Note may will include a term requiring the start-up to repay the investment amount to the investor on insolvency, before making payments to any shareholders. If the SAFE Note contains no liquidation rights, then the investor has no liquidation preference.
• Pro-rata rights –a SAFE Note will usually include terms permitting the investor to purchase additional shares in the company during future fundraising rounds. Pro-rata rights provisions provide anti-dilution protection as they provide the investor with an opportunity to purchase more shares in the company to maintain their equity stake in the business.

What are the advantages to using SAFE Notes?

There are numerous benefits for start-ups using SAFE Notes to raise working capital, such as:

• Simple – SAFE notes require less negotiation between founders and investors than Convertible Notes and direct equity investments.
• Flexibility – unlike a Convertible Note, there is no deadline for when an investment must convert into equity and no maturity date requiring repayment of the investment amount, which means the start-up has more control and flexibility to choose the timing of its next equity fundraising round.
• Valuation – a valuation is delayed until a much higher valuation can be achieved by the start-up.
• Improved cash flow – as there is no requirement to repay the investment amount and no interest accrues on the investment amount, the start-up is less likely to have cash flow and insolvency concerns.
• Attractive – SAFE Notes can be an attractive form of investment because the investor receives shares in the start-up at a discount on the future market value of the shares.

What are the disadvantages to using SAFE Notes?

The potential adverse implications of using a SAFE Note will depend on whether you are an investor or a start-up. The disadvantages of using a SAFE Note include the following:

• High Risk – for investors with a SAFE Note, there is no guarantee that the investor will receive shares in the start-up. The investor will only be entitled to receive shares in the start-up once a specific milestone has occurred (such as an equity fundraising round) which may never occur. The start-up may go into liquidation or may become profitable, negating the need to undertake an equity fundraising round.
• No interest – unlike a Convertible Note, the investor with a SAFE Note does not receive any interest on their investment amount. A SAFE Note that does not convert for a significant number of years can result in a poor return on investment for the investor.
• No dividends – the investor with a SAFE Note is not a shareholder and therefore receives no dividends when the start-up makes profit.
• No liquidation preference – unless the SAFE Note includes liquidation rights, the investor with a SAFE Note is not entitled to any assets of the start-up in the event of a liquidation.
• Dilution – by issuing SAFE Notes, founders can be left not knowing exactly how much of the business they have sold to investors. When the SAFE Notes eventually convert to equity, founders may end up with a smaller percentage of the start-up than they originally anticipated. It is important for founders consider the potential dilution implications of using SAFE Notes in subsequent equity fundraising rounds. To overcome this issue, founders may wish to consider using post-money Safe Notes. The differences between pre-money Safe Notes and post-money Safe Notes will be explored in a future Vault Legal blog.

Key takeaways

Raising working capital can be one of the biggest challenges facing seed stage start-ups. To overcome this problem, start-ups can use SAFE Notes to raise adequate working capital to grow their businesses. However, it is important for founders not to overlook the long-term dilution implications when using SAFE Notes.

Although a SAFE Note can be a useful fundraising tool for start-ups, SAFE Notes are not so ‘safe’ for investors. SAFE Notes offer none of the protections that are available to direct equity investors or convertible noteholders. An investor has no guarantee that the investment will convert into equity.

Whether you are a start-up or investor, it is important to understand the benefits and drawbacks of using SAFE Notes and therefore whether it is the right fundraising vehicle for you and your business.

If you require advice in relation to SAFE Notes, call Vault Legal today on 1300 002 212 or email us at info@vaultlegal.com.au.

If you enjoyed this blog, please also read our blog on Convertible Notes.

Key words: SAFE Note, capital raising, fundraising, founders, Convertible Note, equity, shares, start-up and working capital