It sounds like an easy win. You take $200,000 from an investor right when you need it, with minimal back-and-forth negotiation and no debt obligations or loss of equity in the present.
Sure, there are some strings attached. In exchange for their financing, the investor has agreed to some percentage of ownership in your company at an unspecified future date. But you don’t need to worry about that now—you just secured seed funding without giving up any control in your company or borrowing money you may not be able to pay back.
This is how plenty of founders and entrepreneurs think SAFE notes work. They’re not totally wrong. Compared to other seed funding options, a SAFE note does indeed provide easy access to capital with little upfront labor, compromise, or hassle on anyone’s part. However, a SAFE note is not free money. There are significant risks involved in using this particular investment vehicle—and those risks compound with the more SAFE notes you issue to investors.
But let’s back up.
What Is a SAFE Note?
A SAFE note is a form of convertible security. In other words, it’s something paid for now that turns into something different later. In the context of SAFE notes, that something now is an agreement between a company and investor, and that something later is equity. It’s right there in the name: “SAFE” stands for Simple Agreement for Future Equity.
When you issue a SAFE note, you’re basically taking money from an investor by promising to grant that investor a percentage of ownership in your company at some point in the future. It’s sort of like selling stock, but you get to hold onto the shares for the time being. More precisely, it’s a warrant to purchase stock in a future priced round.
A SAFE note converts into stock when a certain event occurs. That event is almost always a series A financing round or liquidation.
How SAFE Notes Function for Investors
Why would an investor agree to a SAFE note? Because it rewards them for getting in on the ground floor. It allows them to potentially own more of a company and pay less for ownership than others who invest in the business later—e.g. during a series A round.
SAFE notes offer this advantage to investors through discounts, valuation caps, or both.
A discount reduces the price per share for the SAFE note holder when the company actually starts selling stock. Discounts are fixed—typically at 20% or less.
A valuation cap is a more variable kind of discount. It accounts for a possible change in company value between the time the SAFE note is signed and when the company starts selling stock. A lower valuation cap benefits the SAFE note holder, as it sets a ceiling for what they pay for equity in the event the market determines the business is worth more than initially expected.
Some SAFE notes have valuation caps, some have discounts, and some have both. When both are present, the investor can choose to take advantage of whichever option is more advantageous.
SAFE Notes Vs. Convertible Notes
A SAFE note is similar to a convertible note, another form of early-stage financing. SAFE notes and convertible notes both offer future equity to investors in exchange for present-day cash. Both are agreements that convert into shares of preferred stock at the end of a series A round or other “triggering” event.
That said, convertible notes have a few notable differences, including…
- Debt: Convertible notes are debt. SAFE notes are not. Convertible notes are essentially loans that need to be repaid—either through cash or shares in the company.
- Timeline: Unlike SAFE notes, which can be held in perpetuity if the company doesn’t continue raising money, convertible notes have maturity dates. After a period of time (typically 18–24 months), the convertible note automatically converts or must be repaid.
- Interest: Like most debts, convertible notes carry interest. The company must pay back the principal plus interest, or allow the total amount to convert into equity—which can give the investor a far greater share of ownership than what they first “paid” for. By contrast, because a SAFE note is a warranty, not a debt, it does not carry interest.
- Paperwork: Convertible notes tend to be longer and more complicated than SAFE notes, with more terms, provisions, and contingencies for both parties to work out. This is one of the primary reasons SAFE notes were invented as an alternative, and why they’ve become increasingly popular among founders and investors in recent years.
For more about the differences between SAFE notes and convertible notes, read our article here.
So, Why Are SAFE Notes Risky for Founders?
There’s a lot to gain by using SAFE notes to finance your business early on. For one, they offer a great deal of flexibility—you can spend the money now with no obligation to your investor until you begin fundraising in earnest. And you can start fundraising whenever you want, as you’re not under a deadline like you would be had you issued a convertible note instead.
But using a SAFE note has consequences. And it’s perhaps the seeming simplicity of SAFE notes that get founders into trouble, as it’s easy to disregard potential, not-so-tangible risks when very tangible money is on the table.
We dug up a few perspectives from venture capitalists, legal professionals, and business analysts about the often-overlooked downsides of SAFE notes. Here’s what some of the experts have to say:
SAFE Notes Can Put Overly Optimistic Founders in a Bind
Over at TechCrunch, VCs Pascal Levensohn and Andrew Krowne warn founders not to engage in selective thinking about SAFE notes. Consider the upsides and downsides, and don’t confuse the terms of the agreement with detailed financial projections. Don’t assume the valuation cap translates to a real valuation. Most importantly, don’t forget the fact that you’re selling shares of your company.
“We have observed the following in our own recent direct experience investing in SAFE and convertible notes: that many founders have a tendency to associate the valuation cap on a note with the future floor for an equity round; that they further assume that any note discount implies the minimum premium for the next equity round; and that many founders don’t do the basic dilution math associated with what happens to their personal ownership stakes when these notes actually convert into equity.
By kicking the valuation can down the road, often multiple times, a hangover effect develops: Entrepreneurs who don’t do the capitalization table math end up owning less of their company’s equity than they thought they did. And when an equity round is inevitably priced, entrepreneurs don’t like the founder dilution numbers at all. But they can’t blame the VC, they can’t blame the angels, so that means they can only blame… oops!”
The Trouble With Valuation Caps
Whether you issue SAFE notes or convertible notes, it’s important to recognize that you and your investors have competing interests when it comes to valuation caps. Investors want to gauge what a company is worth, but many founders would rather not have the conversation so early in their businesses’ lifecycles.
Startup lawyer Joe Wallin contends that although a valuation cap can be a tricky thing to negotiate, “it may be the key to convincing investors to take a chance on your company”:
“It’s easy to see why convertible note holders like valuation caps, especially when they believe that their early-stage investment will allow a startup to achieve a higher pre-money valuation (compared to the valuation cap) before the next round of financing is completed. From the investor’s point-of-view, if their early-stage, higher-risk investment is what enabled the company to achieve a healthy pre-money valuation, then the investor deserves to be compensated for that—and the valuation cap is an excellent way to do that.
For founders, however, valuation caps can feel like a necessary evil, just one more thing to negotiate while wooing investors. Valuation caps can feel especially problematic since one reason founders prefer convertible notes over fixed-price rounds is because they don’t have to set a value for the company. However, since many investors view the valuation cap as a proxy for the company’s current value, you can still essentially find yourself negotiating the company’s true value during a convertible note seed round.”
Dilution and Overcrowding
One of the most painful consequences of misusing or overusing SAFE notes is equity dilution. The more shares early investors agree to purchase, the less of your company you eventually own when the notes convert. That means less control over your organization’s future. It also means you’ll have a harder time attracting Series A investors.
Using some relatively simple math, Fred Wilson illustrates how a “SAFE or convertible note can ‘crowd out’ new investors in the next round and make it very hard to find a lead investor or any high quality investors.”
“Rude VC” Mark Bivens echoes Wilson’s argument, warning that “VC funds may take a pass on investing because the cascading conversion of notes would consume too much equity.” Bivens also explains why it’s all too easy for founders to lose track of how much of their companies they’re giving away:
“Since SAFE notes do not accompany any immediate dilution until they are converted, some founders fail to model the future dilution impact in their cap tables once all of the outstanding notes convert. One layer of notes is fairly easy to calculate in your head, but two or three layers at different valuation caps and/or discounts can quickly escalate into a more complex set of calculations.”
What Message Are You Sending Investors?
One last note from finance professional and startup advisor Jarod Angehr:
“Offering a SAFE note could also signal to an investor that you, as the issuer, may not be sure about the future of your company. As a founder, you may be able to collect small SAFE checks but once you seek larger investments, you’re going to have a hard time because venture fund managers understand how poorly SAFE notes perform.”
Don’t Guess What’s Best for Your Company or Your Investors
Not sure if SAFE notes, convertible notes, or another seed funding strategy is right for you? Need help preparing for a Series A round or another major stage in your company’s growth?
inDinero has the on-demand accounting, tax, and CFO resources you need. We’ve helped countless companies optimize their financials, connect with investors, and excel throughout their business journeys.
Ask us what we can do for you. Talk to an expert.
Quick Note: This article is provided for informational purposes only, and is not legal, financial, accounting, or tax advice. You should consult appropriate professionals for advice on your specific situation. inDinero assumes no liability for actions taken in reliance upon the information contained herein.