Starting a Business and SAFE Notes

May 19, 2023
Chandler Anderson

What Are SAFE Notes?

Starting a business can be a daunting endeavor. One of the most difficult parts of starting your own company is finding investors to fund it. Securing an investment is a lengthy process, full of negotiations and future interest payments that are difficult for new and small businesses to keep up on. To help these businesses raise capital, SAFE (Simple Agreement for Future Equity) notes were developed in 2013. The purpose behind this was to simplify the process of raising capital in the initial stages of starting a company. SAFE notes were supposed to create a safer way for startups to get investors, and they usually work like this:  

  1. An investor provides seed capital in exchange for promised future equity in the company.
  1. The start-up company uses the original investment to grow the business.
  1. Once the business becomes more successful and gains other investors, the company gets what is known as a post-money valuation.
  1. You can then calculate the company’s new price per share.
  1. After you know the company’s value, you can convert the SAFE note into the corresponding shares of the company and distribute them to the SAFE investor.

Are SAFEs Safe for Investors? What are the risks?

In 2017, the SEC issued a warning against using SAFEs as an investment tool. SAFE notes are different from the promissory notes traditionally used for investment deals, in that they offer only a promise of future equity in a company. Investors only receive the equity when certain trigger events occur, such as a buyout, merger, preferred stock offering, or an influx of outside capital. Therefore, your SAFE may never convert to equity if none of these events occur. On top of that, your SAFE note does not accrue any interest no matter how long you wait for those trigger events. The company is under no legal obligation to grant you equity until one of those trigger events occurs, so you could be sitting and waiting for an exceptionally long time to see a return on your investment.

Start-up investing is always risky as the company you choose to invest in may never succeed, but using a SAFE as your investment tool makes your investment even riskier. As mentioned previously, the investor receives equity only under certain conditions, and SAFEs do not grant you special voting rights or other perks traditional equity investments do. It is only when the company initiates one of those trigger events that you will be granted your equity.

Are SAFEs Safe for Entrepreneurs? What are the risks?

SAFEs can also be risky for the company seeking investments. Because legal obligations that typically protect investors are absent from SAFE notes, it may be difficult to acquire the number of lenders needed to raise sufficient capital for your business.  

If you find investors who are willing to use a SAFE note, there are several factors to consider as a business owner:

  1. Discounts. SAFEs often include a discount for the investor. This means that if the trigger event does occur, the investor will be able to purchase equity in the company at a discounted price, with the discount typically ranging between 10% and 30%.
  1. Valuation cap. This caps the highest price of equity a SAFE noteholder must pay to convert their investment into equity. Valuation caps allow investors to get a better price per share than future investors.

It is difficult to predict how discounts and valuation caps will come into play in the future. If a trigger event occurs, and the SAFE investors receive their promised equity in the company, it is possible that the founder will own much less of their business than they originally did. So, while SAFEs might seem easier to manage on the surface, they also contain known, and unknown, risks.

If You Choose to Use a SAFE For Your Investment...

If you do choose to use a SAFE document for your investment, it is important to understand all the risks associated with doing so. Similarly, it is critical that you understand the terms and rights associated with your SAFE, whether you are an investor or an entrepreneur. Although the purpose of SAFE notes is to avoid legal entanglement, the use of SAFE notes may actually increase it. Consult with an attorney at Sumsion Business Law about the legal strategy of your business.  

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