A SAFE (Simple Agreement for Future Equity) note is an investment contract commonly used by startups to raise capital, allowing investors to convert their investment into equity in the company at a later date.
Here's a more detailed breakdown:
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What it is: A SAFE note is not debt. It's an agreement that gives investors the right to receive company stock if and when the startup raises a priced equity round (e.g., Series A).
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How it works: Investors provide funding to the startup now, and in exchange, they receive the right to convert that investment into equity at a future date, typically during the next qualified financing round.
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Key Features:
- Discount Rate: Investors often receive a discount on the price per share they pay compared to new investors in the priced round. This compensates them for taking early-stage risk.
- Valuation Cap: A valuation cap sets a maximum valuation at which the SAFE note will convert. This protects investors if the company's valuation skyrockets. If the pre-money valuation in the next round is higher than the cap, the SAFE converts as if the pre-money valuation was at the cap.
- No Maturity Date or Interest Rate: Unlike debt, SAFE notes typically don't accrue interest or have a maturity date. This simplifies the agreement.
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Why startups use SAFE notes:
- Speed and Simplicity: SAFE notes are generally quicker and less expensive to negotiate and execute than traditional convertible notes.
- Flexibility: They provide flexibility in fundraising, allowing startups to raise capital without immediately determining a company valuation.
- Defer Valuation: Startups can defer the often-challenging task of valuation until a later, more established stage.
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Why investors use SAFE notes:
- Potential for High Returns: Early-stage investors often seek high returns, and SAFE notes provide a path to equity ownership in potentially successful startups.
- Discount and Valuation Cap: The discount and valuation cap offer downside protection and the potential to acquire equity at a favorable price.
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Example:
- An investor provides \$50,000 to a startup through a SAFE note with a 20% discount and a \$5 million valuation cap.
- Later, the startup raises a Series A round at a \$10 million pre-money valuation.
- Because the \$5 million valuation cap is lower than the \$10 million valuation, the SAFE converts as if the pre-money valuation was \$5 million.
- The investor also receives a 20% discount on the price per share compared to the Series A investors.
In summary, a SAFE note is a streamlined agreement that allows startups to raise capital quickly by promising investors future equity in the company, typically with the benefit of a discount and/or valuation cap.
