Startup financing can often feel like a maze that new business owners attempt to navigate all the time. With the variety of instruments available for funding, it can be hard to keep track. One such option is the safe note, which is often preferred for its simplicity and investor-friendly attributes. If you keep asking the internet, “What is a safe note,” you’re in luck!

Let’s discover some popular definitions and explore how a safe note can impact your investment or fundraising strategy. This guide dives into some of the common questions you may be asking your advisors. It also explains the purpose of safe notes, related advantages, and things you need to consider.

What is a Safe Note: Explained

A safe note, also known as “Simple Agreement for Future Equity,” is an innovative financial instrument that is often used by startups to secure initial funding without having to get the company evaluated immediately.

This concept was first developed by Y Combinator in 2013, whereby the notes were often designed to simplify the usual investment process that occurred when the company was in its initial stages. This process was quite easy and much less expensive than the usual equity rounds.

Here’s an example that can break down the concept for you. Consider this;

A startup raises $500,000 from an investor via safe note with a $5 million valuation cap and a 20% discount. Suppose the startup later achieves a $10 million valuation at the next funding round. In that case, the investor’s safe note converts to equity, based not on the $10 million but on a $4 million valuation (20% discount off the $5 million cap).

Safe Note Explained: The Characteristics

Safe notes are pretty distinctive and easy to understand when compared to many other funding options, such as convertible notes;

1. Valuation Cap

Safe notes often include a cap that sets the maximum valuation at which the investment could be converted into equity.

2. Discount Rate

Investors are allowed to receive a discount on shares once the safe note converts during a future priced round.

3. No Maturity Date

Unlike convertible notes, safe notes do not have a maturity date, which means that there is no real pressure to convert them by a specific time.

4. No Interest

The best feature for safe notes would have to be that they do not accrue interest, which further simplifies the agreement between the investors and the company.

Safe Notes: The Common Benefits

Choosing to gather funding through safe notes can be quite beneficial for both startups and investors. This can be attributed to a few of their popular features;

1. Simplicity and Cost-Effectiveness: Safe notes are less complicated from a legal perspective and have lower administrative costs.
2. Flexibility: There are no real fixed terms for interest or repayment schedules.
3. Investor-Friendly: Safe notes, when converted, offer early investors potential discounts or much more favorable terms.

How Would a Safe Note Typically Work?

Now that you have the answer to, “What is a safe note,” you may wonder, how exactly does it work? To answer this, we need to explore its functions within investment rounds.

Step 1: Issuance

Consider a startup attempting to raise funds, opting for a safe note to avoid immediately valuing the company. The safe note would be offered to potential investors who would agree to provide capital in return to said startup under the terms pre-decided in the safe agreement.

Step 2: Investment

Investors are supposed to provide the startup with the agreed-upon capital in the next phase, in exchange for the safe note document that acknowledges the amount invested and the specific terms under which this investment will convert into equity in the future.

Step 3: Conversion

The conversion of the safe note is where most of the confusion associated with safe notes might exist. This conversion typically occurs when a predefined trigger event happens. This can be one of the following;

• Equity Financing: In case the startup gets to the stage where they conduct an equity financing round (this is where the company gets a valuation), the safe note will convert into equity at either the valuation cap, the discount rate, or the actual valuation (this is decided depending on whatever is most favorable to the investor).
• Change of Control or Sale: If the startup is sold before the equity financing occurs, the safe note is going to convert based on the terms within the agreement specific to the change of control scenarios outlined. This may result in the investor either receiving equity according to the valuation cap or being cashed out at a specific multiple of the initial investment.

Step 4: Outcome

Once converted, the investor’s safe note gives them equity in the company and is effectively settled. The investors benefit from the equity increasing in value if the company grows favorably.

Safe Notes vs. Convertible Notes

Although both instruments defer the valuation to a later stage, they have key differences;

1. Interest: Convertible notes accrue interest, which adds to the amount that will be converted into equity.
2. Maturity: Convertible notes typically have a maturity date that can pressure startups into a conversion or a repayment, often avoided by safe notes.

Are There Any Risks?

While safe notes are pretty much “safe” there are always risks to doing something without knowing a lot about it. Often, founders may face substantial dilution if the company’s valuation significantly increases before the note converts.

Moreover, relying heavily on safe notes might delay necessary valuation discussions, which can complicate financing rounds in the future.

FAQs

1. How does a safe note differ from traditional equity?

Safe notes are a financial tool for startups to raise capital without determining its value. Unlike traditional equity, safe notes defer valuation until a future financing round. This allows investors to convert their investment into equity at potentially favorable terms, based on future valuations, without negotiating ownership percentages.

2. What happens to a safe note if the company is sold before a conversion event?

If a company is sold before a safe note converts into equity, the terms of the safe typically include a provision for this scenario.

In many cases, the safe note will have a “change of control” provision that allows the investor to either;

(1) Convert the safe into equity at the cap amount or a discount rate prior to the sale.

(2) Be repaid their investment, possibly with a premium.

The specific outcome depends on the terms negotiated in the safe agreement.

3. Are there any specific conditions under which a safe note might not convert?

A safe note may not convert if the company doesn’t undergo financing or is not sold within the expected period. Also, if a subsequent financing round doesn’t meet certain conditions, the safe might remain outstanding until specific terms are met or renegotiated.

4. How can startups and investors mitigate risks associated with safe notes?

Both startups and investors can mitigate risks associated with safe notes by:

• Outlining Terms Clearly: Ensuring that the terms of the safe note are clear and comprehensive, covering scenarios like subsequent financing rounds, the sale of the company, and what happens if these events do not occur.
• Cap and Discount: Setting realistic caps and discount rates that reflect the potential growth and risk profile of the startup.
• Legal Advice: Consulting with legal professionals who specialize in startup financing to tailor the safe note to the specific needs and expectations of both parties.
• Open Communication: Maintaining open lines of communication between investors and founders to address any concerns or changes in the startup’s trajectory that might affect the safe note.

5. Can safe notes be negotiated between startups and investors?

Yes, safe notes are highly negotiable between startups and investors. While they typically follow a standard format to keep the process simple and cost-effective, specific terms such as valuation caps, discount rates, and provisions for early exits or additional protections can be tailored to suit the preferences and risk tolerance of both the investor and the startup.

6. What are the latest trends in using safe notes for startup financing?

The use of safe notes continues to grow, particularly in the tech and startup sectors, where rapid scaling and uncertainty in early valuations are common. Recent trends include:

• Increasing Popularity: Broader acceptance and use of safe notes beyond Silicon Valley, including international markets.
• Variations and Innovations: Development of new types of safe notes that include additional terms or structures to address specific investor or startup needs.
• Focus on Fairness: Greater emphasis on creating balanced terms that protect both founders and investors, reflecting lessons learned from earlier rounds of startup financing.

Final Thoughts

Now that we have the safe note explained, let’s weigh the importance of the concept. Safe notes are essential for startup financing rounds as they are a lot more flexible and efficient than other routes. That is often exactly what a startup might be looking for.

However, it is essential to make an informed decision, under the trusted guidance of a CFO who knows what they are doing. Don’t think a full-time CFO is something you can afford at this point? Not to worry.

Monily offers fractional CFOs that you can bill by the hour so you can get the advice you deserve without it putting a hole in your pocket. Still unsure? Contact us today and learn more about how we can help!

Wajiha Danish

Wajiha is a Brampton-based CPA, CGA, and Controller with 17+ years of experience in the financial services industry. She holds a Bachelor of Science Degree in Applied Accounting from Oxford Brookes University and is a Chartered Certified Accountant. Wajiha spearheads Monily as its Director and is a leader who excels in helping teams achieve excellence. She talks about business financial health, innovative accounting, and all things finances.