Is a SAFE (Simple Agreement for Future Equity) a safe alternative to Convertible Notes?
Learn about the differences between a SAFE and a Convertible Note
In my previous article on convertible notes, I had written about many of the hidden traps with convertible notes. A SAFE financing instrument, which was developed and popularized by Y-Combinator, avoids many of the pitfalls of a convertible note. Like a convertible note, a SAFE can have a valuation cap and a discount to the price of a future priced equity round. Note that unlike a note, the valuation cap used in a SAFE is a Post money valuation cap (as compared to convertible notes which use pre-money valuation caps) which allows the amount of dilution suffered to be calculated exactly. A SAFE is also somewhat more cost efficient compared to a note given its simplicity. As a result, SAFEs are increasingly being utilized instead of notes, especially in Silicon Valley.
Let’s say that a founder initially raises $500K at a $5.5 million post money cap. The dilution they would suffer would be:
$500K/$5.5 million = ~9%
Subsequently, the founder raises another $500K at a $8.3 million post money cap. The dilution that they would suffer would be:
$500K/$8.3 million = ~6%
In total, the company would have suffered ~15% dilution by issuing the two SAFEs.
Here are the notable differences between a Convertible note and a SAFE:
Equity vs Debt Instrument
A SAFE is intended to be an equity instrument compared to a note which is a debt instrument with a convertible feature. It is essentially a warrant for future equity in the company. A SAFE has no maturity date and no interest rate. Given that it is not a debt instrument and has no maturity date, you don’t have the risk of non-payment at maturity and being at the mercy of your investors who can potentially force you into bankruptcy.
Pre-Money vs Post Money Valuation Cap
With a note, the valuation cap is a Pre-money valuation cap whereas with the current form of a SAFE, the valuation cap is Post-money. The advantage of having a Post-money valuation cap is that both the investors and the founders know exactly how much dilution they have suffered through the SAFE even if the company issues raises more capital with additional SAFEs in the future. However, the cost of dilution from future SAFEs is borne entirely by the founders. With a note, the exact dilution is not known until a future equity round is raised and existing note investors suffer dilution from future note investments.
Note that typically, even though the amount of dilution that the company suffers from a SAFE is known when it is issued, like a note, you typically don’t see a SAFE showing up on the Cap table. This is because the valuation of a future priced round could be lower than the valuation cap of the SAFE in which case more shares will be issued to SAFE holders and they will suffer even greater dilution.
No “Free” Liquidation Preference
As discussed earlier, notes have the issue of having a “free” liquidation preference i.e. that you can have a liquidation preference higher than the amount invested by note investors. With a SAFE, the amount invested converts to its own series of preferred stock with amount of liquidation preference equal to the amount invested as a SAFE.
Pro-Rata Rights
A SAFE provides for a side letter option that allows investors get pro-rata rights in a future financing. As an example, if an investor owns 20% of the company, they get the right to invest 20% of a future round. Typically, you don’t want to give this right to small investors who are common in seed financings. When a VC gives you a term sheet for an investment, they typically want to invest the whole amount and don’t like reducing their investment for smaller investors who have pro-rata rights.
However, a SAFE has some of the same issue of including a Full Rachet Anti-dilution provision as a convertible note.
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