A common hurdle faced by many early-stage start-ups is trying to raise capital where the company has not yet attained sufficient financial information and/or market data in respect of the business, which makes it difficult to assign a justifiable and substantiated value to the company.

SAFE (simple agreement for future equity) notes are documents that start-ups may consider using to help raise seed capital where there is limited financial data, and or a consistent source of revenue over a tracked period of time.

A SAFE note is a legally binding promise that allows an investor to purchase a specified number of shares for an agreed-upon price at some point in the future.

How SAFE Notes Work

For most start-up companies there is typically very little financial information and/or market data in respect of the business, making it difficult to assign the company any value. SAFE notes work by allowing you to postpone your company's valuation until a later date (the post-money event).

Example of how a SAFE Note works:

1. An investor provides seed money to a start-up in exchange for promised future equity in the entity;
2. The company uses the original investment to build the business;
3. Once another investor invests in the company (known as post-money valuation), the company can calculate a new price per share using the information;
4. After the share price is known, the company can convert the SAFE note into the applicable number of shares in the company, and distribute them to the SAFE investor.

Key Elements in a SAFE Note

SAFE notes contain a few primary terms that alter how they eventually convert to company shares, and they are:

1. Discounts: SAFEs sometimes apply discounts, usually between 10% - 30%, on future converted equity. This means that the investor will be able to purchase shares at a discount on the future financing.
2. Valuation Caps: Valuation caps are a term in SAFE notes that establish the highest price, or cap, that can be used when setting the conversion price.
3. Most-Favoured Nation Provisions: Where there are multiple SAFEs, this term requires that the company notify the first SAFE note holder, including the terms for the subsequent note. If the first SAFE holder finds the second SAFE's terms to be more favourable, they can ask for the same terms.
4. Pro-Rata Rights: Pro-rata, or participation rights, allow investors to invest extra funds so that they can keep their percentage of ownership during future equity financing.

Types of SAFE Notes

When issuing a SAFE note, you can choose from four different scenarios:

1. No valuation cap and no discount
2. A valuation cap and a discount
3. A valuation cap, but no discount
4. A discount, but no valuation cap

The Advantages of Using SAFE Notes

Simple and less complex documents
One of the primary benefits of SAFE notes is that they are typically short and simple agreements with fewer commercial items to negotiate. The key items to be negotiated are the discount rate and the valuation cap. SAFEs are meant to be simple arrangements with fewer terms to negotiate, making everything that needs to be discussed clear and concise.

Key triggers on certain events
SAFEs protect both start-up companies and investors by including key agreements for potential future occurrences, such as:

• Changes of control
• Early exits by investors and company owners
• Company dissolution

Simple accounting requirements
SAFE notes are included in a company's capitalisation table, eliminating the need for any complicated tax consequences.

Better benefits for investors
Since SAFE notes are converted into shares, often at a discounted price, investors have a lot of incentive to use them.

There are risks to using SAFE Notes
Because a SAFE note's outcome depends on how the company performs, investors don't have a guarantee that it will ever convert into equity.

No interest paid on monies advanced
SAFE notes do not provide investors with interest payments on the monies advanced.

No dividends paid until notes convert to equity
The investor pays funds upfront for a SAFE Note, which is a promise to receive equity in the future. Only once the equity is issued in the investee company will the investor be entitled to receive dividends (if any) when declared by the company.

If you are thinking of raising capital or looking to invest in a start-up, always seek legal and financial advice.

Holman Webb’s Business, Corporate and Commercial Group have high-level experience acting for both investors and investee companies, and can provide advice and assistance regarding fundraising,  investments, transactions, corporate governance and directors duties.