In a capital-constrained market, should more startups play it SAFE?

For some startups, raising capital has become an arduous task, and extending runways is all they can think about. But cutting costs can only go so far before cash in hand is needed. Unfortunately for many startups in the current market, raising money while preserving valuations will not be easy.

Enter SAFE notes.

Created by famed accelerator Y Combinator in 2013, the simple agreement for future equity note was designed for very early-stage startups looking to raise funds. Essentially, investors agree to give capital on the condition that they will receive equity in the future.

Many startups use SAFE notes for early-stage fundraising. In this climate of uncertainty, investors predict its popularity will only grow—and not just at the earliest of stages.

“We’re seeing that startups are having more difficulty getting priced rounds done,” said Erica Duignan Minnihan, co-founder and general partner of New York firm Reign Ventures. “Since we’re in a capital-constrained market, there are going to be more bridge rounds, and I think we’ll see more SAFEs come in to fill that.”

For the uninitiated, a SAFE works similarly to a convertible note. However, it’s structured as an equity instrument rather than debt. Issuers and investors don’t have to settle on a valuation upfront, but the price is fixed at a later date with a future equity round or liquidity event.

SAFEs are designed to be simple to use—one simply downloads and fills out a template—saving startups the costs and effort that come with a convertible note or a priced equity round. The main features often included in SAFEs are:

• Valuation cap: This refers to a predetermined maximum valuation for equity once a SAFE is converted.

• No maturity or interest rates: Unlike convertible notes, SAFEs are designed to expire only when the holder has received equity or cash. Because it’s not debt, there are no interest payments.

• Discount: Investors receive a discount off the price per share paid by new investors in a subsequently priced equity round with around 20% being the norm.

When it comes time to convert, SAFE investors can take advantage of either the discount or the value cap at the moment of conversion—whichever is more favorable. Not every SAFE has both a valuation cap and a discount rate, but it’s uncommon for it to have neither.

For example, let’s say a startup offers a SAFE to an investor for $100,000 with a valuation cap of $10 million and a discount rate of 20%. If it were to achieve a valuation of $12 million, the investor would convert to equity at $0.96 per share, whereas the non-SAFE investors would pay $1.20 per share due to the discount rate. If the company were to be valued at $15 million, then the SAFE investor would pay $1 per share because the valuation cap is set at $10 million compared to the $1.50 for the other backers.

Aside from their ease of use, the main benefit of SAFEs for startups is that they don’t have to be priced immediately. This makes them more attractive in the context of the current market where valuations have been under increased pressure.

In the US, VC median pre-money valuations saw declines at the end of 2022 across both early and late-stage, according to PitchBook’s 2022 Annual US VC Valuations Report. Q4 saw early-stage fall 33.3% from the first quarter of the year to $40 million for early-stage, while late-stage saw a 25% decline from the same quarter in 2021.

In order to avoid a haircut, more startups may opt for a SAFE in the hopes that their next priced equity round achieves a higher valuation than what they would get if they raised now. Therefore, SAFEs could take the form of a bridge round, intended not to replace a traditional equity deal but to help startups extend their runway until market conditions improve.

"[SAFEs] can be beneficial from that perspective because it will essentially allow the company to raise at a lower valuation without everyone having to mark down their positions,” Duignan Minnihan said.

Late-stage companies are also benefiting from this instrument. In March, Magnolia Medical Technologies raised a $46 million Series D in the form of a SAFE, which was then converted. Fintech startup Denim‘s September Series B, which totaled $126 million, also contained SAFEs.

The risks of SAFEs

But there’s a catch. Using SAFEs amid a downturn can present risks for startups, according to Kruze Consulting COO Scott Orn, particularly if their next priced equity round disappoints.

“Investors who put money into a SAFE during the go-go days, anticipating six months to a year from now that the valuation will be higher, are seeing valuations below the cap,” Orn said. “They’re benefiting from the discount, but they’re also owning more of the company than entrepreneurs anticipated. [SAFEs] have essentially become less founder-friendly.”

Even if a startup does get follow-on funding and at a higher valuation, the fact that their price tag is not set at the time of the SAFE can be a drawback. Future investors in a startup that has used a SAFE will use the valuation cap (if it has one) as an indicator of how they will price the company. If it’s set too low, startups may sell themselves short for the future—although in this market, that’s probably less of a concern.

But investors are the ones who are the most at risk if a SAFE defaults. With no maturity date or liquidation preference, there’s no guarantee that investors will get their money back if the startup can’t raise follow-on funding—plus, there’s no interest paid over the term of the SAFE.

Given their relative simplicity, SAFEs don’t provide the same level of investor protections as traditional equity investments, including board observer rights or antidilution provisions. SAFEs are not equity stakes until a triggering event such as a priced equity round occurs. This means that if the company goes bust, investors may not be able to convert their SAFEs into equity, which would result in a total loss of investment.

In this regard, “safe” may be something of a misnomer in some circumstances, and caution is advised. But SAFEs may still be the best option for companies hoping to avoid a drop in valuation.

Featured image by Jenna O’Malley/PitchBook News