Both investors and entrepreneurs need to understand the way that convertible securities convert, and they need to understand dilution.
The safe and its predecessor, the convertible note, have almost identical conversion features. So not understanding the effects of conversion is not a new problem that the safe specifically created. Rather, the ubiquity of using low-resolution fund-raising documents has created a larger universe of people (investors, founders, lawyers) grappling with conversion language.
It is important to note that priced equity rounds are preferable to using safes because all parties better understand how dilution works. Unfortunately, priced rounds are not as simple and fast a funding mechanism as safes (or other convertible securities).
The transaction costs of a Series A round average $60,000 dollars, and the industry standard is that companies pay for BOTH their own legal counsel and the investor’s legal fees. That standard practice is not safe for entrepreneurs. There are several other non-obvious pitfalls for founders when doing priced rounds (including the potential loss of board control, the consequences of which may be even more poorly anticipated than dilution), and priced rounds take longer. More often than not, the trade-offs make the safe a better choice for early-stage startups.
SAFE (or simple agreement for future equity) notes are documents that startups often use to help raise seed capital. Essentially, a SAFE note acts as a legally binding promise to allow an investor to purchase a specified number of shares for an agreed-upon price at some point in the future.
SAFE notes are a type of convertible security, while convertible notes are a form of debt that can convert into equity once certain milestones are met. Because of this, convertible notes usually have a maturity rate and an interest rate. Though convertible notes are a bit more complex, both SAFE and convertible notes are:
When a company is first starting out, there is typically very little data, making it difficult to assign the company any value. SAFE notes work by allowing you to postpone your company's valuation until a later date. Here's a look at the basic steps that take place when utilizing a SAFE note for your startup:
SAFE notes contain a few primary terms that alter how they eventually convert to company shares, and they are:
When issuing a SAFE note, you can choose from four different scenarios:
There are several benefits of using SAFEs, including they:
One of the primary benefits of SAFE notes is that they are typically less than five pages long and are simple enough for anyone to understand. This is largely due to the fact that there aren't any end dates or interest payments to worry about, unlike with a convertible note.
SAFEs protect both startup companies and investors by including key agreements for potential future occurrences, such as:
Have Simple Accounting Requirements
SAFE notes are included in a company's capitalization table, eliminating the need for any complicated tax consequences.
Provide Fewer Points for Negotiation
Since SAFEs are so simple, there are fewer terms to negotiate, making everything that needs to be discussed clear and concise. In fact, the only things that really need to be negotiated are the discount rate and the valuation cap.
Give Company Owners More Control
Without repayment obligations and maturity dates looming over your head, you end up having a lot more freedom and flexibility as a company owner.
Offer Better Benefits for Investors
Since SAFE notes are converted into preferred stock, often at a discounted price, investors have a lot of incentive for using them. Investors could end up with benefits that are actually better when compared to their original investment.
SAFE notes offer a number of benefits, but they do come with their fair share of challenges, such as they:
Can Be Risky
Because a SAFE note's outcome depends on how the company progresses, investors don't have a guarantee that it will ever convert into equity.
Don't Offer Continual Revenue
Convertible notes provide investors with continual interest payments. SAFE notes aren't a loan, meaning investors don't receive any sort of interest or payments. As a result, investors sometimes end up making less over time.
Don't Provide Dividends
A lot of companies provide dividends, either in the form of payments or additional shares, to investors when the company performs well. In most cases, SAFEs don't supply investors with dividends. Instead, an investor's reward for investing in a SAFE is equity.
Have an Unknown Future Impact
SAFEs weren't developed until 2013, when the team at Y Combinator , a Silicon Valley accelerator, decided that there needed to be a financial tool that made seed investment a little less complicated. In the short-term, this new financial instrument is efficient and effective, but we're still unaware of the potential long-term consequences for company owners and/or investors. Additionally, the newness of SAFE notes means that investors and lawyers are often less familiar with them, and, therefore, wearier of using them.
Require the Business To Be Incorporated
In order to use SAFE notes during negotiations, a company has to be incorporated. This is because this type of investment is included in a C corporation's capitalization table, just like other stock options. That means that if you're hoping to issue SAFE notes and your business is structured as a limited liability company, or LLC, you will have to:
May Necessitate a Fair Valuation
Another possible expense associated with issuing SAFE notes is the potential need for a fair valuation, also known as a 409a , to appraise your startup stock's fair market value.
Lack Minimum Requirements
SAFEs don't have a minimum requirement for equity to enter conversion, which can have a negative impact on future investments. Minimum requirements allow you to readjust the note's terms, giving smaller investors the opportunity to compete.
Could Dilute the Company's Valuation
Company owners could unknowingly end up owning fewer shares in their company down the road because they forget to account for any potential dilution. As a result, investors will be less inclined to invest in the company.
As a startup, finding funding is often one of the very first challenges that you'll face. By knowing your options and learning about their advantages and disadvantages, you can make the right decision for you and your company. SAFE notes, while still fairly new, provide an excellent opportunity for you to develop your business without the threat of impending interest payments looming overhead.
There you have it.
We are building an inventory of templates and spread sheets of legal and finance documents for startup founders. Please make sure you utilize all these resources to your benefit.