SAFE notes: What startup founders need to know

SAFE notes, often referred to simply as SAFEs, are an increasingly popular way for early-stage startups to secure financing. In the first half of 2023, SAFEs were roughly five times more common than convertible notes.

If you’re interested in raising capital for your startup with SAFE notes, here’s what you should know about them, including how they work, their pros and cons, and how they compare to other funding options.

What is a SAFE note?

A SAFE note, or a Simple Agreement for Future Equity (SAFE), is a type of convertible security that grants investors equity in your startup at a future date, typically whenever your Series A funding round occurs.

First introduced by the Y Combinator in 2013, SAFE notes are an alternative to convertible notes for early-stage startups. They offer many of the same benefits without drawbacks like interest payments, maturity dates, and debt regulation compliance.

Compared to convertible notes, SAFE notes are also relatively straightforward, allowing founders to raise capital quickly without as much negotiation upfront.

How SAFE notes work

When you issue a SAFE note, you receive capital that you can use to help grow your startup. 

In exchange, the SAFE investor receives the right to convert their SAFE note to preferred shares in your company after a triggering event, which is generally your next priced equity round.

Until the priced round or liquidation event, you retain full ownership of your business, and because there’s no debt component to the note, you don’t have to worry about interest or repayment.

Once the triggering event occurs, the SAFE note’s valuation cap or discount rate determines how much equity the investor receives.

If the SAFE note uses a valuation cap, it sets an artificial limit on your company’s valuation for the purpose of calculating your investor’s equity. Your investor benefits if your company’s value has grown since their initial investment.

For example, say an investor buys a SAFE note from your startup with a SAFE valuation cap of $5M. When the triggering rond occurs, your company is valued at $10M, with a share price of $20 per share. 

The SAFE note converts based on the $5M valuation cap, giving your investor an effective share price of $10 and doubling their number of shares.

If the SAFE note uses a discount rate, your investor’s note simply converts to shares at a discounted price, granting them that much more equity. Discount rates typically range from 5% to 30%.

For example, say an investor buys a SAFE note from your startup with a discount rate of 20%. When the triggering round occurs, your shares are valued at $10 per share, but the safe note converts as if they cost only $8.

Types of SAFE notes

SAFE notes can fall into one of four types. Here’s what they are and how they work:

• Capped SAFE: These SAFEs include a valuation cap but no discount rate. Investors may prefer a capped SAFE if they believe the company’s value will exceed the cap by the time of the triggering round.
• Discounted or uncapped SAFE: These SAFEs include a discount rate but no valuation cap. Investors may prefer a discounted SAFE if they aren’t confident they’ll benefit from a valuation cap.
• Capped or discounted SAFE: This type of SAFE includes a valuation cap and a discount rate. Investors get to convert using whichever approach benefits them most when the triggering event occurs.
• Most Favored Nation SAFE: These SAFEs don’t include a valuation cap or a discount rate. Instead, they allow investors to receive the same terms as the best deal subsequently offered to any other investor.

Each type of SAFE note can also be classified as either a pre-money SAFE or a post-money SAFE. A pre-money SAFE calculates the investor's equity based on the valuation before the trigger event, while a post-money SAFE calculates it after.

The practical impact is that pre-money SAFEs spread the effect of equity dilution across all shareholders, while post-money SAFEs protect investors from it.

SAFE vs. convertible note

SAFE notes and convertible notes are both convertible securities that eventually provide an investor equity in your startup. They’re popular among early-stage startups because they allow you to raise capital without determining a valuation upfront.

However, there are notable differences between the two that have contributed to SAFE notes becoming more popular in recent years, at least in some industries. The two most significant include the following:

• Complexity: SAFE notes are designed to be simple and require less negotiation than convertible notes. Not only do they have fewer moving parts, but they also tend to include standardized deal terms.
• Repayment obligations: Unlike SAFES, convertible notes are a convertible debt instrument. That means they accrue interest, and if they aren’t converted into equity by their maturity date, you typically have to repay them.

Many startup founders prefer SAFE notes. Not only do they provide an easier way to raise capital quickly, but they also allow you to avoid the stress of accumulating interest and potentially having to repay your proceeds at a maturity date.

Whether investors prefer SAFEs or convertible notes often depends primarily on their risk tolerance. Convertible notes offer more investor protection in the form of interest and repayment requirements, which SAFEs lack. 

SAFE notes vs. other funding options

SAFE notes are an increasingly popular early-stage startup financing option, but they’re far from the only one. Here’s how they compare to some of the alternatives you might be considering:

• Friends and family: Financing from your personal network often provides favorable and flexible terms, but it can strain your relationships if your business doesn’t succeed. In contrast, SAFE notes formalize terms and tend to follow a more consistent structure.
• Debt financing: Traditional business loans are often cheaper than SAFE notes in the long run and preserve your ownership of your company, but they require monthly payments of principal and interest, which can be financially burdensome.
• Accelerators and incubators: These programs connect you with investors who can offer guidance and resources, but they dilute your ownership upfront. SAFE notes preserve your equity until the trigger event, but you won’t receive as much assistance from your investors.

Ultimately, every funding type has its pros and cons, and the right one for you depends on your circumstances. In addition to your priorities and preferences, that includes which financing opportunities are actually available to you.

SAFE note advantages

SAFE notes have become one of the go-to funding options for early-stage startups for several reasons. Here are some of their most significant advantages:

• Reduced need for negotiation: SAFE notes are intentionally straightforward, with fewer terms to discuss than traditional convertible notes. That may result in shorter negotiations, helping you raise money sooner and reducing your legal fees.
• Lack of debt obligations: Unlike convertible notes, SAFEs don’t accrue interest or require you to repay them if they don’t get converted by a maturity date, which can make them much less financially burdensome.
• Delayed equity dilution: SAFEs allow you to raise capital without immediately granting any ownership rights to your investors. That allows you to defer equity dilution until your first financing round.

SAFE note disadvantages

SAFE notes are one of the most popular early-stage financing options, but they may not be right for everyone. Here are some of their potential disadvantages:

• Unpredictable equity dilution: If your SAFE agreement includes a valuation cap, there’s no way to know how much ownership you’re giving up until the triggering event. If your valuation is lower than you expected, you could face greater equity dilution than you wanted.
• Investor aversion: SAFE notes have become popular in recent years, but some investors may be wary of them. They can be riskier for investors than convertible notes that require repayment and more traditional equity arrangements that offer immediate ownership.
• Valuation delays: By design, SAFE notes let you delay finalizing your valuation until a later funding round. That’s convenient at first, but it can also make it more difficult to negotiate with future investors and make informed financial plans.

Tax and accounting considerations for SAFE Notes

When deciding which type of fundraising makes sense for your business, you should consider its effect on your taxes and accounting in addition to its potential impact on the growth of your operation.

SAFE notes actually have an advantage in this area, as they were designed specifically to help the SAFE issuer avoid the complex regulatory and tax challenges associated with issuing debt.

Because SAFEs don’t have an interest rate, require repayment, or create liabilities on the balance sheet, they create a much lighter tax and accounting burden than convertible notes and traditional business loans.

In fact, most tax questions regarding SAFEs are posed by the SAFE note holder, not the issuer. That primarily includes whether each SAFE should be considered stock or a hybrid financial instrument, like an option to purchase stock.

This distinction has significant tax implications for the investor. For example, if it’s characterized as stock from the moment it's issued, it extends the investor’s holding period for long-term capital gains and QSBS exclusion purposes.

How SAFE notes impact future fundraising rounds

SAFE notes are an especially attractive option in the short term, as they can help you generate capital quickly with relatively few downsides upfront. However, they have an impact on your future financing round that you must understand.

Here are some critical considerations:

• Unpredictable dilution at triggering round: The more you use SAFEs to raise capital, the more difficult it becomes to manage your cap table and predict how much dilution you and other shareholders will experience during their conversion.
• Investor overhang concerns: Future investors may also be concerned about overhang, which is the potential dilution they’ll experience when each SAFE converts. That can make negotiations tougher during later funding rounds.
• Delayed fixed valuation: SAFE notes delay a fixed valuation until the triggering round. That can be beneficial since you’ll have more data by then, but it can also increase the pressure from early investors to achieve a favorable valuation.

Should you consider using a SAFE?

If you’re an early-stage startup founder, SAFE notes are well worth considering. They can be an effective way to raise capital quickly and without many of the complexities associated with other early-stage options.

Most notably, they help you avoid the tax, accounting, and regulatory challenges involved in issuing convertible notes. They’re also less financially burdensome since they don’t accrue interest or create repayment obligations.

However, SAFEs also have their downsides, including uncertainty regarding equity dilution, which can be worrisome for you and the potential investors you hope to partner with in your eventual equity financing round.

Before you decide one way or another, it’s essential that you do your due diligence and develop a long-term fundraising plan. SAFE notes are a great option but don’t get so caught up in their benefits that you fail to adequately plan for their drawbacks.

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