What is a SAFE note

A simple agreement for future equity (SAFE) is an equity financing instrument that was developed by Y Combinator in the United States. The SAFE instrument was designed to accelerate the seed funding round for startups by providing a standard, short document (usually five pages) to simplify negotiations.

The crux of a SAFE instrument is that the investor will be agreeing to pay money to a startup in exchange for a contractual right to subscribe to equity when the startup reaches a defined trigger event (usually either a series A equity financing round, or alternatively, an exit event such as an initial public offering).

What is the difference between a SAFE note and a convertible note?

Although SAFE instruments are commonly called “SAFE Notes”, they should not be confused with convertible notes.

Convertible notes are debt instruments (with an option to convert into shares). If the investor does not choose to convert their convertible notes into shares, then the company will be obliged to repay the face value of the convertible note to the investor. Convertible notes usually also require the company to pay the investor interest payments (commonly called “coupons”).

Under a SAFE instrument, the company will have no obligation to repay the investment amount, and this is true even if the SAFE instrument never converts into equity. The only exceptions to this are:

1. if the company achieves an exit event before the investor’s SAFE instrument coverts into shares, then the investor will have the option to redeem their investment amount or convert into shares; or
2. if the company goes into liquidation before the SAFE instrument convert into shares, then the investor will be entitled to repayment of the investment amount. The investor will usually rank equally with preferred shareholders (i.e. between debt holders and ordinary shareholders). There is also no interest payable on SAFE instruments, as they are not debt instruments.

Different types of SAFE

There are four different types of SAFE instruments:

1. valuation cap, no discount;
2. discount, no valuation cap;
3. valuation cap and discount; and
4. most favoured nation, no valuation cap, no discount.

Valuation cap

A valuation cap sets a ceiling on the conversion price to protect investors’ upside in their investment before their SAFE instruments convert into shares. It is important to understand that a valuation cap is not a valuation of the company.

Discount

A discount will enable investors to convert their SAFE instruments into shares at a discount. The discount means they will receive more shares for their initial investment than they would have done if they were participating in the equity round normally.

Most favoured nation

A most favoured nation clause will entitle an investor to swap their SAFE instrument for future convertible instruments issued by the company, if those convertible instruments were offered on more favourable terms than the investor’s current SAFE instrument.

What are the downsides?

The downsides to SAFE instruments are:

1. SAFE instruments do not have maturity dates, so it is possible that a SAFE instrument will never convert into equity; and
2. SAFE instruments restrict investors from transferring their rights under a SAFE instrument, so a SAFE instrument will be an illiquid investment until it is converted into shares (and even then, the investors will be subject to any pre-emptive rights contained in the applicable shareholders’ agreement or company constitution).