What is a SAFE Note and other financial instruments?

What is a SAFE Note?

A SAFE Note (Simple Agreement for Future Equity) is a straightforward financial tool used by startups to raise money. Created by Y Combinator in 2013, it’s a simple agreement between the investor and the startup. Unlike traditional loans or bonds, a SAFE doesn’t charge interest or have a specific time frame for repayment. Instead, it offers investors the chance to convert their investment into equity (ownership) when the company reaches certain conversion triggers, such as a priced round of funding or other liquidity events, which are predefined in the SAFE agreement.

CrowdSAFE

CrowdSAFE is an adaptation of the traditional SAFE note, designed specifically for equity crowdfunding platforms. It follows the same basic principles as a SAFE but is tailored to work in a crowdfunding environment where many small investors come together to fund a startup. CrowdSAFE is typically used in equity crowdfunding under Regulation CF, part of the JOBS Act, which comes with specific compliance requirements.

Both of these SAFE type instruments are designed to reduce the burden of managing multiple shareholders on a company’s cap table.  Since they are not shares and do not have individual voting rights companies do not have to face issues with voting as they would with traditional share issuances.

The investors in these instruments benefit from the growth in the company’s valuation based on a discount or valuation cap placed on their conversion from SAFE into shares.  Conversions are triggered by some specified future events such as the next round of financing, going public, sale of the company or its assets.

SAFE Notes vs. Convertible Notes

SAFE notes and convertible notes are often mentioned in the same breath because they serve similar purposes—they both convert into equity at a future event. However, there are some key differences:

• Debt vs. Non-Debt: A convertible note is essentially a loan to the startup. It accrues interest, and it has a maturity date. If the startup doesn’t raise a qualifying round of funding or reach a specific milestone, the note could become due, requiring repayment. In contrast, a SAFE is not a debt instrument. It does not accrue interest and doesn’t have a due date, making it less risky for startups. However, SAFE notes do not obligate the company to repay the investor if no conversion event occurs, making them higher risk for investors compared to convertible notes.
• Complexity: Convertible notes can involve more legal complexity and require negotiation over terms like interest rates, conversion terms and maturity dates. SAFE notes, on the other hand, are much simpler, with fewer variables to consider, making them more appealing for early-stage companies.
• Risk to Investors: For investors, convertible notes might offer slightly more protection because they have a clearer claim on the company’s assets if things go wrong. SAFE notes are more of a gamble on the future, betting that the company will eventually become valuable enough to convert the agreement into worthwhile equity.

Other Financial Instruments

Besides SAFE and convertible notes, there are other financial tools that investors and startups and investors can use to structure their fundraising deals. Each has its unique features, helping companies to choose the approach that best aligns with their needs.

Keep reading and expand your knowledge discovering more about other financial instruments like options, warrants, promissory notes, ICOs and STOs.

It is important to keep in mind that there is still a market for private company shares, whether common or preferred shares.  Shares usually offer investors influence on the company through voting rights and provide an opportunity to participate in dividends (if declared and depending on the security’s rights) or upside in the stock price on any future exit events. Private company shares usually carry some form of trading restrictions depending which regulation they were issued under, so always look at the details.

Options and Warrants

Options and warrants give investors the right to purchase a company’s stock at a set price by a certain future date. While they may sound similar, there are differences between the two:

• Options are usually offered to employees or advisors as part of a compensation package. They serve as incentives, encouraging employees to help grow the company’s value so they can eventually purchase stock at a favorable price.
• Warrants, on the other hand, are often issued to investors or broker-dealers. They allow investors to buy more shares in the future, typically at a price agreed upon at the time of the investment. Warrants can be a great way to sweeten a deal for investors who want to share in the company’s growth.

Promissory Notes

A promissory note is a simple financial instrument where the startup agrees to pay back a specific amount of money to the investor by a certain date, often with interest. Unlike SAFE notes or convertible notes, promissory notes don’t automatically convert into equity. They are straightforward debt agreements. Promissory notes are useful for startups that need quick cash but are not ready or willing to offer equity. They’re also attractive to investors looking for a lower-risk, fixed return on their investment.

Initial Coin Offerings (ICOs) and Security Token Offerings (STOs)

With the rise of blockchain technology, new forms of fundraising have emerged, including Initial Coin Offerings (ICOs) and Security Token Offerings (STOs):

• ICOs involve creating and selling digital tokens to investors, who typically buy them using cryptocurrencies like Bitcoin or Ethereum. Investors hope the value of these tokens will rise as the startup grows, similar to buying shares in a traditional market. However, ICOs have faced increased regulatory scrutiny, particularly by the SEC, who tend to view these as securities.
• STOs (or digital securities as they are often referred), offer tokens that are backed by real assets like company equity or revenue streams. They are subject to more regulations and are generally considered safer than ICOs. STOs are subject to compliance under securities laws such as Regulation D or Regulation A+.

These methods allow startups to tap into a global pool of investors, opening up more opportunities for funding. However, they also come with increased scrutiny and legal requirements.

Understanding Your Options

SAFE notes and convertible notes provide distinct benefits for startups looking for funding. It’s important to evaluate your situation and seek advice from financial experts to find the right financing choice for your business. By knowing the different options, you can make smart decisions in the challenging area of startup financing.

Whether you’re a startup founder or an investor, understanding these financial instruments can help you navigate the complex world of fundraising with confidence and clarity.

Disclaimer: Investors, issuers, and investment professionals are encouraged to conduct their own research and consult with legal counsel before utilizing any financial instruments. Kore is not responsible for any decisions made or actions taken based on the use of these instruments. Please note: This information is for informational purposes only and should not be considered legal or investment advice.