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SAFE notes: Basics to a safe gateway to startup investment

In the complex world of startup financing, Simple Agreement for Equity, better known as SAFE, is a tool to ease the process for both entrepreneurs as well as investors. Though it is a new investment instrument, in the recent years, it has gained a lot of popularity.

What is SAFE exactly?

SAFE is much like the very common startup seed investment instrument convertible notes. Even it was introduced to the startup ecosystem by Y Combinator in 2014 just to replace the shortcomings of the latter.

SAFE has almost all the features of convertible notes. However, it is not a debt instrument. So the entrepreneurs do not have to hassle with the investors negotiating interest rates and maturity period.

It can be simply defined as a startup seed financing instrument which lets an investor invest an amount in the company, and in exchange, he/she will receive the right to receive stocks of the company in a future equity round based on certain parameters.

After pitching the idea of SAFE in 2013, Carolynn Levy, a lawyer and a partner at Y Combinator, told TechCrunch: “In the securities world, there’s debt, and there’s equity. But if everyone wants to own equity in a company, why would you use debt as an investment instrument?”

Advantages of SAFE

The biggest selling point of SAFE over convertible notes is that it is not a debt instrument. So none of the investors or the entrepreneurs has to worry about regulations, interest accrual, maturity dates, the threat of insolvency and in some cases, security interests and subordination agreements, related to debts. These requirements can have unintended negative consequences for both the parties.

Moreover, unless there is a Most Favoured Nations (MFN) clause in the agreement, SAFE will automatically convert into equity in the earliest equity round.

In 2016, Sydney-based startup Uprise raised $200,000 by issuing SAFE notes. Jay Spence, the founder of the firm, said: “The SAFE note is basically saying that you will have a valuation that’s far more accurate in 9-12 months and this is a foot in the door for an investor who may not get another opportunity.”

“It’s for the early-stage person that believes in the startup when there isn’t much to show yet, and it’s time-saving for the business,” he added.

Conversion parameters

Primarily, there are three parameters to draft a SAFE – valuation cap, discount rate, and MFN – which decide the conversion rate of stocks.

The valuation cap is the maximum valuation of the firm based on which the issued SAFE will convert upon a priced round unless the discount applies. The discount rate applies to the price of each share of the preferred stock sold in the next equity financing round.

However, if the calculation results in a greater number of shares of SAFE preferred stock for the investor, the price per share based on the valuation cap is disregarded. That means the investor is always rewarded for taking the financial risk of investing in a nascent firm.

Moreover, if the company subsequently issues SAFEs with provisions that are advantageous to the investors holding this SAFE, it can be amended to reflect the terms of the later-issued safes, and this amendment is known as MFN provision.

SAFEs are not always safe

Despite all the advantages, SAFEs have drawbacks too and most of them target the entrepreneurs.

Startups often opt for successive funding rounds with SAFE or even with convertible notes, because of its simplicity, without properly considering its impact on the future valuation of the firm and the dilution implications.

Andrew Krowne, a principal at Levensohn Venture Partners and Dolby Family Ventures, wrote at TechCrunch: “…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 capitalisation 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!” he added.

Also, too many liabilities of notes on a startup often push the VCs back as those will consume a massive chunk of the equity.

Moreover, unlike the vibrant US startup industry, the Australian startup investment market is more conservative, and investors are hesitant in betting in the early stage of a company. The lack of valuation often keeps them at arm’s length. And in the less competitive investors market, it is harder to raise money with SAFE than convertible notes.

“SAFE notes mean less risk for the founder and more risk for the investor. In an accelerator like Y Combinator where angels are falling over each other to get in on a first round, and funding rounds are much closer together, SAFE notes can work. In Australia, where there’s less competition between investors, less momentum and less FOMO, it’s definitely harder to raise on a SAFE note than a convertible note, and harder to raise on a convertible note than on a priced equity round,” Alan Jones, entrepreneur-in-residence at the Sydney-based startup incubator BlueChilli, wrote last year.

Conclusion: Is there any solution?

Before issuing any new SAFEs, entrepreneurs should consider their implications – whether they will add value in the valuation round or if they are suitable for current development stage. Awareness, in the part of both issuer and investor, is needed to get benefit from the investment in the future.

The importance of corporate experience for start-up
SAFE notes: Basics to a safe gateway to startup investment
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The importance of corporate experience for start-up