Raising capital is among the top priorities of startup companies. As a result, startups receive money from investors in various ways. One of those ways is through a Simple Agreement for Future Equity (SAFE). A Silicon Valley accelerator, Y combinator, created this document in 2013 to allow startups to structure seed capital without interest or maturity dates. Specifically, a SAFE is a legally binding contract that permits an investor to buy shares in a company for an agreed-upon price at some time in the future.
As you consider your options to seed your startup, you should understand the benefits and disadvantages of SAFEs and how they differ from convertible notes.
Benefits of Using SAFE Notes
Startups who choose to use SAFE notes for seed funding enjoy various benefits, including:
- They are simple financial instruments that are only a few pages long, straightforward, and easier to understand for most.
- They have simple accounting procedures because they are included in a company’s capitalization table, so startups may not have to deal with problematic tax issues on a regular basis.
- The only features that are typically negotiable are the valuation cap and discount, unlike other investment instruments.
- They offer provisions for early exits, change of control, and dissolution, like other convertible securities.
- Delayed conversion to equity, which can happen after distributing preferred shares.
- Startups have more freedom because they do not have predefined terms and specific maturity dates hanging over their heads.
Disadvantages of SAFEs
SAFE Notes are not perfect instruments. They also have some risks and drawbacks, including:
- SAFEs are unofficial financial instruments for raising capital, potentially leaving investors without equity from their investment.
- Startups that offer SAFEs are almost always incorporated as a C-Corp. LLC’s typically don’t offer them, so LLC startups may need to restructure or amend their organizational documents.
- SAFEs are “new,” so investors do not have as much experience with them as they do with convertible notes. In the near future, many find SAFEs effective and efficient, but those who use SAFES are unsure about the long-term impact for founders and investors.
- Companies might have to allocate resources, such as legal and accounting fees, for a fair valuation.
- Some investors shy away from SAFEs because of lower returns. With no interest, investors don’t make the same money, especially if they hold the note for more than a year. Additionally, SAFEs do not pay dividends.
SAFEs vs. Convertible Notes
A SAFE is a financial instrument similar to a stock option or warrant. Investors who hold a SAFE can buy company shares in a future round of capital funding. Ultimately, SAFE notes were designed in opposition to some negative aspects of convertible notes, so many investors and founding members of startups find them attractive. Most startups prefer SAFE notes over convertible notes because they are not debt, so they do not accrue interest. Convertible notes carry an interest rate that ranges from 2% to 12%, with most falling around 5%. Additionally, SAFEs do not include specific maturity dates like convertible notes.
Similarities between SAFE notes and convertible notes include:
- Both agreements can offer a discount in the upcoming round of financing.
- Both agreements can come without a valuation cap if a company has a good traction and strong negotiating skills.
- Both agreements offer similar payouts for early exits when a change of control occurs, such as an acquisition or IPO.
- Both convert into equity in a future priced round.
- Both notes usualy have value maxims, savings, and MFN clauses.
An Experienced Attorney Can Help You Raise Capital for Your Startup
As you launch your new project, you want to do as much as possible to save money and preserve capital. However, raising additional capital and planning for rounds of funding for your startup requires the insight of an experienced startup attorney. Contact the Law Office of Elliot J. Brown today to learn whether SAFE notes or convertible notes are a better source of funding for your startup.