A SAFE Note is an agreement between a startup and an investor which warrants rights to the investor in owning future equity of the startup.
They’re an evolved form of convertible security but aren’t a debt instrument.
They have been gaining traction in India since 2019 ever since a Mumbai – based VC firm decided to invest in 100 high growth startups in the span of 12 months using a SAFE Note document.
In India, SAFE notes take the legal form of Compulsorily Convertible Preference Shares (“CCPS”) as governed by sections 42, 62 and 55 of Companies Act, 2013.
How did they come about and how do they operate?
SAFE Notes Origin Story
Once upon a time, in the deep recesses of Silicon Valley, there was a startup accelerator named Y Combinator.
It helped new businesses with resources and mentorship.
There was no easy way to get financial support for the founders once the seed funds were exhausted and the startup wasn’t scaled enough to go the route of angel investing.
In 2013, this accelerator created SAFE notes – Simple Agreement for Future Equity.
The name is pretty self-explanatory; the investor will simply give financial aid to the startup in exchange for future equity, or ownership, once the next investment triggers the Safe.
Here, simple is the keyword because there’s minimal paperwork (6 pages) to be signed to kickstart this funding process.
SAFE notes aren’t exactly a novel concept. They are an evolved rendition of Convertible notes but without the interest rates or maturity dates.
Let’s get deeper into this.
Definition
A SAFE note allows a startup to take on an investment that will convert into equity in the future. Before fully understanding them, one needs to understand Convertible notes.
- Every startup has a valuation, but in the early stages, it’s not possible to know what it is due to the idea still working through the implementation process. Valuation is impacted by certain economic events or corporate earnings which goes through analysis via various
- Uncertainvaluations waste a lot of time as both the investor and the founder negotiate on differing valuation expectations
- ThroughConvertible notes, founders can raise capital quickly and the investor gets equity in the company at a later trigger event
- They carry both the aspects of financing; debt and equity
- The finance given by the investor are a loan to begin with; they convert into equity after a period of time
- The founders can grow their startup despite the uncertainty of valuation, whereas the investors can be assured that they will either get their money back with interest or get shares.
A SAFE note is also a somewhat similar Convertible security except that the aspect of loan and interest rate is not there. This means that the founder does not have to worry about the impending maturation date, tricky legal paperwork, or paying back the interest rate.
An absence of a maturity date means that it’s up to the founder to convert the investment into equity at preferred timings rather than obligatory ones.
How do SAFE Notes Work?
Unclear startup valuations and a quick need for funding lead to the utilization of SAFE notes.
- In India, the startup should come under the Act as a private company and be registered as a startup with the Department for Promotion of Industry and Internal
- The investor and the founder enter the agreement where the investor provides the initial finances to get the cogs of the wheel running in exchange for a future equity
- The startup is now free to use this money to finance various aspects of their business – from hiring to product development (and more)
- After certain progress, the founder might need more Once another investor decides to invest in the startup at the priced round, the startup gets a post-money valuation
- The new price per share is then calculated
- Now, the SAFE note can be converted into the number of shares the new investor owns from the startup
Key Terminologies
Discount
Assuming that this is one of the very first investors for your startup, they might want to ensure a discount on purchasing shares by the time future financing occurs.
They will be able to buy the shares at a discounted price rather than what’s established through valuation. This is the reward for taking a very high risk.
Valuation Cap
The SAFE investor again may want to pay a better price for the shares than other investors. A Valuation Cap is the highest price that can be used at which the initial investment will be converted into equity.
If the startup is able to raise funds at a valuation that is more than the cap, the SAFE investor can still convert the shares at a price equal to the cap.
There can be times when the SAFE agreement will have both these deals. In such a situation, only one of them is applicable at the choice of the investor.
Qualifying Raise
Typically, there is the lowest amount to raise to trigger the SAFE to convert to equity, so if the startup raises a small amount it wouldn’t trigger the SAFE to convert.
Types of SAFE notes
There are 4 types of safe notes as follows
- Cap, no discount
- Discount, no cap
- Cap and discount
- MFN, no cap, no discount (Most Favored Nation keeps the next round of investors from getting better terms, thus a rewarding feature for the first investors)
Can any Startup Use the SAFE Note Agreement?
To use a SAFE note agreement, your company has to be included in the C Corporation Capitalization table (against being a Limited Liability Company).
To put it simply, a C Corp has a board of directors or management and is taxed twice (earnings and salaries). LLC, on the other hand, has multiple partners or members rather than owners.
C Corporations tend to have a certificate of incorporation and generally come with a “cap table”. Cap table is just a descriptive list of which entities own what elements, like stocks, equities, and more.
Rise in India
In the Western corporate hemisphere, there is a rapid uptick in opting for the SAFE template by startups and angel investors.
South Asian and South East Asian areas, however, saw the numbers to be much lower.
The unprecedented circumstances of the Covid 19 Pandemic triggered a need for those investment processes which were quick to implement and secure in its legality.
For instance, Mumbai Angels Network (MAN) resolved to offer startups a minimum investment of ₹50,000 along with innovative solutions via SAFE Notes.
Tyke Invest, on the other hand, initiated a digital platform through which entrepreneurs connect with investors. Investment starts as low as ₹5,000 and the agreement is a T SAFE one.
The traction seems to be improving in India due to its nature being fast paced lacking tedious legal paperwork.
Benefits of Using SAFE Notes
Simplicity
These agreements are simple enough for anyone to understand and just come with 5 – 6 pages. There are no mentions of interest rates or maturation dates.
Useful Agreements
SAFE Note agreements are inclusive of all the legal stipulations of future events like bankruptcy, change in control, dissolution of the startup itself, early exits of any party, discounts, and valuation caps
No Accounting Horrors
SAFE Notes are always included in the startup cap table. Hence, the risk of consequences that can happen through tax is reduced to nil
Negotiation
These agreements carry simple and concise terms with minimal stipulations. This makes them less time consuming and easier to understand especially for newbie entrepreneurs
Flexibility
Since SAFE Notes aren’t debt instruments, more control lies with the founder. The founder knows what to expect via the agreement later on and can exercise full freedom (compare this with Convertible notes which charge 2% – 8% of interest rates on the debt).
More Choices for the Investor
Discounts and Valuation Caps protect the investor’s interests and give them incentives to fund more for the purpose of maintaining their shares.
Drawbacks of Using SAFE Notes
Risks
SAFE Note agreements come with a lack of guarantee that the investment will ever reach a point where it can be converted to equity.
Revenue Issues
A lack of interest payments can be a turn off for the investor as they might perceive their profits to be less in the longer run
Mandatory Incorporation
When an LLC tries to restructure itself to fit the C Corp status for the purpose of complying with a SAFE note agreement, it costs them a lot of time, resources, and legal fees
Dividends
SAFE Investors are not entitled to dividends (as compared to profits other kinds of investors get when the company is performing well). In this way, the only reward for the SAFE investor
is the promise of equity.
Conclusion
SAFE Notes are worth considering in India as the valuation is impossible to determine during the startup’s seed stage; the focus is majorly on the idea, product, and founders over the startup’s scalability.
These instruments offer an alternative solution to such a situation for both the entities (company and the investors). As more and more angel investors and VC firms are interested in funding startups even at the seed stage, SAFE Notes are gaining momentum.
It’d be fair to say that the seed stage funding is the new cool. It’s not just attracting the big shots but also more young and savvy investors. Such changing trends demand the entire process to be accessible and seamless.
