Understanding SAFE Notes: A Strategic Tool for Fintech Startups

In the dynamic world of fintech startups, securing funding efficiently can significantly impact growth. One financial instrument gaining popularity is the Simple Agreement for Future Equity (SAFE) note. SAFEs were introduced by Y Combinator in 2013 to simplify early-stage investments. This post explores their utility for fintech startups, the benefits they offer, key drafting considerations, and their influence on exit strategies and future fundraising.

How SAFE Notes Can Benefit Fintech Startups

SAFE notes are contractual agreements promising future equity in exchange for immediate funding. Notably, they aren't debt instruments; they don’t accrue interest or have a maturity date. This lack of immediate repayment obligations is especially beneficial for fintech startups that need quick capital without financial burdens.

Their advantages include:

Speed and Simplicity: The simplicity of SAFE notes is compelling. They avoid the immediate need for a company valuation, which is often a significant challenge in a startup’s early life.

Flexibility: The flexibility in negotiating SAFE terms is a key advantage. This is particularly useful in the ever-evolving fintech sector.

Lower Legal Costs: Given their standardized nature, SAFE notes often lead to reduced legal costs. This is advantageous in fintech startups, where funds are tight before funding.

Key Considerations in Drafting a SAFE Note

Roughly speaking, a SAFE note presents the following investment opportunity:

• An investor contributes a certain purchase amount, in dollars, to a startup. Because the company’s valuation is not yet discernible in the market, that dollar contribution is not immediately converted into equity.
• If the startup subsequently sells equity interests in a fundraising round (Section 2(a) in the model below), with the market thereby providing proof of the company’s appropriate valuation, the investor’s initial purchase amount is then (or in the next fundraising round) converted to equity based on that now-established valuation, typically at an agreed discount to reward the investor for joining early and bearing the risk of those early days, and often with a cap placed on the observed valuation so that the investor can participate in part in any meteoric rise in the company’s valuation that precedes that fundraising round.
• If the startup gets acquired before an equity round establishes its valuation (Section 2(b) below), then the investor gets the choice of converting its initial purchase amount into stock in the acquiring company at a price set in the acquisition (if the investor likes that price) or receiving its purchase amount back (if the investor does not like the proposed price).
• If the startup goes out of business before establishing its valuation or getting acquired (Section 2(c) below), the investor gets its money back, to the extent the company has funds sufficient to cover that obligation.
• And if the startup just trundles along for a while without raising money, getting acquired, or going out of business, the investor simply retains its same rights — unlike with a convertible note, the investor typically does not earn interest during this period or hold the right to demand its money back, events that tend to put pressure on founders who issue convertible notes instead.

While such SAFE notes offer a valuable fundraising structure to many startups, they require careful drafting to align with specific needs and goals.  Among the things to keep in mind include:

Valuation Caps and Discounts: These terms are crucial. A valuation cap sets the maximum valuation for equity conversion, benefiting investors if the startup's value increases sharply. Discounts allow equity conversion at prices lower than those offered to later investors.

Pro Rata Rights: For startups likely to seek more funding, these rights are important. They allow investors to maintain their ownership percentage.

Regulatory Compliance:  In fintech’s strict regulatory environment, compliance with securities laws and regulations is mandatory.

Thus, at its core, a sample SAFE note will typically include at least the following topics and look something like this, plus lots of legal terms not covered in this simplified model:

Company: Tech Innovations Inc.
Investor: John Doe Ventures
Date: May 6, 2024
Principal Amount: $500,000

1. Purpose
   This SAFE grants the Investor the right to certain shares of the Company’s Capital Stock, subject to the terms described below. The Company will use the investment primarily for product development and market expansion.
2. Events
   a. Equity Financing: If the Company issues shares in a priced equity round, the Investor will receive a number of shares of the most senior class of stock issued in that equity round equal to the Principal Amount divided by the lower of (i) the share price from that priced equity round, reduced by the Discount Rate, and (ii) the Valuation Cap multiplied by the fractional interest in the Company represented by such a share, and the investor will then have no further rights under this Section 2.b. Liquidity Event: In the event of a Liquidity Event, the Investor will receive either (i) a cash payment equal to the Principal Amount, or (ii) the number of shares of Common Stock equal to the Principal Amount divided by the Liquidity Price, at the option of the Investor, and the investor will then have no further rights under this Section 2.c. Dissolution Event: If the Company is dissolved, the Investor will receive a payment equal to the Principal Amount and will have no further rights.
3. Valuation Cap: $10,000,000
4. Discount Rate: 20%
5. Pro Rata Rights Agreement: This SAFE entitles the Investor to a right of first offer on a pro rata basis in future rounds.
6. Most Favored Nation (MFN): If the Company issues more favorable terms to other investors in another SAFE, those terms will apply to this SAFE.

How Can SAFE Notes Impact Exit Strategies and Future Fundraising?

Exit Strategy Considerations:  Without a maturity date, SAFE notes do not guarantee a timeline for investment returns, and this can impact an investor’s expectation of exit strategies.  It is important to have clear communication about potential exits with the founders, and even then the realities of business can affect the best laid plans.

Effects on Future Fundraising: The use of SAFE notes can dilute equity during subsequent funding rounds. This might complicate negotiations with new investors and affect company valuation.

Conclusion

SAFE notes are an efficient capital-raising tool for fintech startups. They facilitate growth and scalability by aligning the interests of founders and investors without the pressure of immediate debt repayment. However, understanding the terms and implications of SAFE notes is crucial for leveraging them effectively. Careful consideration and strategic planning can help fintech startups use SAFE notes to establish a strong foundation for success.

If you are a fintech founder or early-stage investor looking to structure a fundraising round, please contact Ziliak Law, and we will be happy to help you decide whether SAFE notes are right for you and tailor them to your needs.

Article by R Tamara de Silva