Once regarded as one of the investment community’s ‘stranger things’, SAFE Notes occupy the twilight zone between the usually binary alternatives of debt and equity. That is, unless certain events occur, they are neither. Whilst newer in Australia, these instruments have been around since 2013, when Californian start-up accelerator, Y Combinator, released the original SAFE document to the Silicon Valley investment community. Below we look at the mechanics of SAFE Notes and their benefits for Australian start-ups.

What is a SAFE Note?

SAFE is an an acronym for ‘Simple Agreement for Future Equity’. A SAFE instrument is a legally binding agreement between a start-up entity and an investor. They were created as a simpler alternative to Convertible Notes and increasingly are presented to investors in a largely standard form of agreement, rather than being heavily and uniquely tailored to a specific company transaction.

SAFE Notes essentially investors the right to purchase equity in the company in the future. This means that they are not debt instruments and do not accrue interest. Instead, the investor provides funding to the start-up in exchange for a portion of future equity, often at the same time as the company’s first arms length priced round of equity financing (Qualifying Financing). When converted, the SAFE Note investment is measured against the Qualifying Financing round and typically attracts a discount of 10% to 30%. In addition, the Qualifying Financing round valuation may be subject to a ceiling or a cap.

Key Elements of SAFE Notes

Below are the key elements of how a typical SAFE agreement works under Australian law.

1. Qualifying Financing: The SAFE Investment Amount automatically converts to equity at a discount to the next Qualifying Financing round, with the amount of equity usually determined by four main factors:

• SAFE Investment Amount: E.g. $100,000
• Qualifying Financing Valuation: E.g. $1.5m
• Discount Price against Qualifying Financing Valuation: E.g. 25%; and
• Optional Valuation Cap: E.g. $2m

2. Exit Event: Alternatively, if before the Qualifying Financing occurs, there is an Exit Event, the investor can choose to either receive: 

• The return of the SAFE Investment Amount; or
• Shares based on the lower valuation of either the Exit Event Price or the SAFE Investment Amount.

3. Insolvency Event: If before the Qualifying Financing Event or Exit Event occur, there is an Insolvency Event, then:

• The company will pay the investor the SAFE Investment Amount and the payment will be given in priority over any distribution to shareholders.
• However, if the company’s assets are not sufficient to cover the payment to the investor and other SAFE holders, the assets will be distributed proportionally among the SAFE holders.

Appeal of SAFE Notes for Early-Stage Companies

There are a number of reasons why SAFE Notes can be appealing to start-ups.

• SAFE Notes are simple and increasingly standardised agreements that do not need to be tailored to the individual investor. This can save time and resources on negotiating the terms of the instrument between parties.
• SAFE Notes do not require a company valuation at the time of investment, which may be difficult when the company is pre-profit or even pre-revenue.
• SAFE Notes allow founders to maintain their equity in the early stages of the company.
• As SAFE Notes do not have a maturity date, the company does not have to convert the SAFE Note into equity at a particular point in time (unless a trigger event occurs).
• As they are not debt, a SAFE investor is not a creditor and the SAFE investment amount is not recorded as debt in the Company’s books.

Some Other Matters to be Aware Of

As appealing as SAFE Notes look to be for early-stage companies, there are still some risks that companies and investors alike need to be aware of.

• If the company becomes insolvent or if a trigger event does not occur, SAFE investors will have to rely on the liquidation of the company assets to receive any compensation for their investment.
• Despite being around for a decade in the US, SAFE Notes are not yet the norm in the Australian market. Therefore, investors tend to require more education and information about them, which may have a chilling effect on investment.
• Some experienced investors may be unwilling to subscribe for SAFE Notes.
• Founders should be aware of the risk of dilution when utilising SAFE Notes in the early stages of their company, especially when a cap is deployed.

Concluding Remarks

In an environment of increasing economic instability and uncertainty highlighted by the recent collapse of Silicon Valley Bank, Australian corporate software provider, Cake Equity, released data showing an increase in the use of SAFE Notes by start-up companies in Australia. With simpler terms and no maturity date, these once ‘strange things’ offer a flexible solution for Australian start-ups that is becoming increasingly popular and accepted.

At Edwards + Co Legal, we regularly advise on the suitability and terms and conditions of SAFE Notes. Early stage companies wondering if SAFE notes are right for them, or investors being asked to channel their investment through this kind of instrument, are welcome to contact us for advice as below.