This is a guest post on Tallyfy by Jake Severn about SAFE notes
Jacob Severn is a certified scrum product owner who specializes in product strategy. Jacob’s passion in writing is to make complex subjects easier to digest. He also writes poetry on the side. Reach him at jacobsevern.com
What is a SAFE note?
A story about dreams, dollars and … funding!
Marisa and Kyle were both business majors at University of Iowa when they conceived of their small business idea: an app which provided ratings for various meetups at their college. They later realized the idea could apply to meetups everywhere as well! Kyle helped build a minimum viable product, and a landing page with a sign-up for the website (Rate-It.com). Within a few days and some targeted ad spend on Facebook and Instagram, Rate-It.com had 500 people interested!
Marisa conducted some research, and found 5 ways to raise capital for a business:
|Bootstrap||Funded by Marisa and Kyle by eating Ramen and scrounging change from every couch they see|
|Equity and Reward Crowdfunding – i.e. SAFE notes, Crowd SAFE, Convertible Note/debt, Common or preferred shares through Reg A+, KISS||Funded by other people who like the product vision|
|Small business loan, Credit cards||Must have some good business already, high interest rates|
|Friends and Family||#Awk|
|Angel Investor, Venture Capitalists||Difficult to attain|
The Case for Crowdfunding
Marisa and Kyle began to compare and contrast the various funding vehicles out there to see what they should do to scale. They decided off the bat that friends and family, small business loans, credit cards, and bootstrapping were not ideal. Venture Capitalists and Angel Investors seemed feasible, but not for their initial seed round funding (money to get the business started) due to the need to scale quickly over a very short time period (has driven many an early stage startup to an early grave).
They really liked the idea of crowdfunding for their initial fund. They needed to find investors, and they wanted them to be dedicated and highly interested in the project. The initial funds would also enable the business to get off the ground in order to create a more compelling story for the larger investment rounds asked of VCs and Angel Investors.
Before we go further with Marisa and Kyles’ story, we will take a dive into some definitions. We will start with defining what an accredited and non-accredited investor is. After that, we will dig into what crowdfunding is, and then how various crowdfunding mechanisms work.
What is private investing, and what are accredited investors and non-accredited investors?
For the longest time, private investing for the average American was limited to companies publicly listed on a stock exchange like the New York Stock Exchange. What’s the difference between Accredited and Non-Accredited investors anyways? In order to be an Accredited Investor, you must either have a net worth $1 million or make at least $200,000 per year (Rule 501 of Regulation D of the U.S. Securities and Exchange Commission). If you don’t meet either of these requirements, you would be classified as a Non-Accredited investor.
In order to make a private company publicly available on the NYSE, for example, the company must undergo an initial public offering, which is commonly referred to as an IPO. Before the IPO, one stock, or share price, must be determined. This occurs through an evaluation of the company’s health through profit, loss, growth, and other key metrics. Typically, this work is done by 3rd-party investment bankers, lawyers, and other teams. Once all parties have come to an agreement and a date has been decided, all available shares at the IPO price are listed on the exchange. Historically, this was the only way for non-accredited investors to privately invest. This restriction was due to the Securities Act of 1933, which was intended to keep investors from putting money into investment vehicles which they did not have the experience or skill set to evaluate.
The Jumpstart our Business Startups (JOBS) Act of 2012 changed the investing environment, by opening up pre-public investment opportunities to non-accredited investors. This includes opportunities for crowdfunding – a term that means raising small amounts of money from large amounts of people (for example, Kickstarter). Historically, investors from Crowdfunding opportunities typically received an early-adopter incentive from limited-edition apparel to major discounts. One key thing to note is that Crowdfunding investing may or may not include ownership in the company.
The four types of crowdfunding are:
- Rewards based (Kickstarter, Indiegogo). Individual people donate as much or little as they want, and in return receive some sort of reward.
- Donation Based (GoFundMe, DonorsChoose). Individual people donate as much or little as they want to the cause they choose to support.
- Debt Crowdfunding (P2P Loans – LendingClub, Prosper). Individual people loan out money with an expectation of a return on investment once the loan is paid back.
- Equity Crowdfunding (Republic, SeedInvest, WeFunder, StartEngine). Individual people buy a piece of a company, with the expectation that its value will increase as the company has success. This category is often where you find SAFE notes.
What is a SAFE and why does it matter?
SAFE (Simple Agreement for Future Equity) is an instrument for startup equity crowdfunding introduced by startup incubator Y Combinator. SAFEs came about in 2013 as a way to raise money prior to a Series A round (the next round of private investment following the first funding/seed round). SAFE notes allow founders to bypass the usual route of Venture Capital funding by a wealthy individual or institution or the use of a convertible note.
The predecessor to SAFE notes – convertible notes, did not define so absolutely the terms of the shareholders equity. The value of the equity was variable, depending on how little or much money a company could raise, making the future value of a share of a company hard to quantify. Additionally, convertible notes sometimes came with a guarantee of a certain percentage (e.g. 5%) back on the investment after a certain date (the maturity or realization date).
SAFE notes gave early-stage startups a way to raise money without needing to provide a guaranteed return on investment, or meet an arbitrary timetable set by a maturity date. The SAFE holder would then traditionally be able to participate in the next round of fundraising as well. A SAFE note is partially defined by what it is not: it is not debt or equity, with no maturity date or guaranteed return of interest.
Prior to 2018, the amount of SAFE money raised could be changed to include the valuation of the company after the fundraising was already complete. This sometimes resulted in the inclusion of SAFE investors in the terms for the next funding round and subsequent dilution of the SAFE note value. Dilution occurs when an investor buys in to a company with a valuation cap of $12m, and the funding round raises $1m, the investor now holds a piece of equity in a company worth $13m, but their slice of the pie is smaller because of that. Each SAFE note agreement outlines the future value of each share based on the value of the company during the SAFE fundraising round.
SAFE notes are now post-money” meaning the valuation of a company includes the valuation of the company before fundraising, plus the value of total money fundraised. As of 2018, SAFEs are now a separate round of fundraising all their own, instead of being included with later rounds. This prevents both de-facto liquidation and the onboarding of investors into following funding round negotiations.
The terms outlined in a SAFE note agreement typically consist of these basic items:
- minimum investment amount
- valuation cap
- whether the SAFE is offered at a discount or not (there can be additional perks or considerations depending on how the company wants to carry out the investing round).Ã
The valuation cap is the maximum value of the company. A discount implies so that whatever the future value of the share is, the note owner will get a certain percent-discount off the future value (For example, if a share is $18/share, and a safe holder initially invested $200 at a 20% discount, this gives the SAFE holder $200/14.4 instead of $200/18 shares). This is the difference between owning 11.11 shares and 13.88 shares). SAFEs convert to common stock or cash in the case of an IPO or acquisition. Click here to read more about common stocks.
The four types of post money SAFE notes center on these components discussed above:
- cap, no discount (valuation cap, no discount on equity)
- discount, no cap (discount on equity, no valuation cap)
- cap and discount (valuation cap and equity discount)
- MFN (most favored nations), no cap, no discount. This type allows the investor to switch to the terms of the next fundraising round if it is more favorable for them.Ã
The post money SAFE note structure allows founders to more easily see what percentage of the company they have sold. It also allows investors to more easily predict the stock’s future value.
Equity itself is complicated, as the future value company is impossible to quantify. Additionally, owning equity is no guarantee of monetary value, and usually comes at high risk to the investor. Equity, convertible notes, and SAFEs are all largely illiquid and not easily converted into cash like stocks are. The time horizon for these investment vehicles is often 8-10 years, with a business survival rate of 33% after 10 years. If there is no IPO or acquisition, SAFEs can lose all of their value (https://link.medium.com/ejSkD6WMy4).
CROWD SAFE – Simple Agreement for Future Equity?
Crowd SAFE notes came about as a legal way to enable non-accredited investors to own a piece of whatever crowdfunding opportunity they were supporting*. This goes beyond simply providing money, and enables conversion of the Crowd SAFE into stock or cash in the future, giving the opportunity for easy future liquidation. Additionally, CROWD SAFE enables companies at an early stage (pre-seed, seed, Series A) to raise funds in place of traditional VC, or in complement to it. CROWD SAFEs differ from a SAFE because the valuation of the company does not include equity raised during the fundraising round. The Crowd SAFE uses the same components of the SAFE discussed above, and is similarly illiquid. The value of a Crowd SAFE does change based on triggering events like an IPO, or an acquisition of a startup by another company. Like SAFEs, there is no guaranteed return on investment and the investment can lose all of its value. Some CROWD SAFEs have terms which are unfavorable to investors, and would allow companies to buy back all of their issued SAFEs at the original cost, instead of paying out the increased value. This why the SEC is considering removing or changing them as a fundraising option. https://crowdwise.org/regulations-and-0law/overview-of-secs-proposed-updates-to-reg-cf-and-exdmpt-offering-framework/”
Additional Crowdfunding Opportunities
(Keep It Simple Securities) are an iteration of SAFE notes. There are two versions: one which is similar to a convertible note because there is a maturity date (18 months) and a guaranteed version that offers a certain converstion value in equity. The second converts to equity and does not have a guaranteed interest rate or maturity dates. All KISS contain a MFN clause. KISS noted usually have a minimum financing round of $1 million, and convert to equity at that value. If there is a sale of the company prior to equity conversion, the investor can choose to receive a multiple of their investment or convert at the valuation cap or assigned value, similar to a SAFE note. Unlike SAFE notes, KISS notes can often be transferred to anyone, at any time.
Regulation A+ of Title IV of the JOBS act allows companies to raise up $3 – $50 million from the public. These investors do not have to be accredited. Companies choose Reg A+ to build a user base who will organically market for the company, reward early-adopters, retain control of their company, and raise money fast. The downsides are the cost of legal and accounting fees, 2-3 months for regulatory approval, the higher number of investors, and the requirement of ongoing public reporting (see link below for more detail: Reg A+ specifics are broken down by the Tier of fundraising chosen to file under).
Regulation D of the Securities and Exchange Commission is similar to Reg A+,; but is only open to accredited investors. Reg D is typically offered under two rules, 506(b) private placements (no general solicitation), and 506(c) which can be done on portals such as WeFunder. It’s much less burdensome on the startup and far fewer disclosures are required, so it’s much easier and cheaper for the issuers.
Comparison at a Glance
|CON. NOTE||SAFE||CROWDSAFE||KISS||REG A+||REG D|
|Optional Conversion at Maturity||Optional||N||N||N||N||N|
|Optional Conversion at Acquisition||Y||Y||Y||Y||N||N|
|Most Favored Nation||Y||N||N||Y||N||N|
Pros and Cons
|CONV NOTE||Guaranteed rate of return (investor)||Less configurable (business)|
|SAFE||Configurable Terms (business)||No guarantee of return (investor)||Less leverage (investor)|
|CROWD SAFE||Configurable Terms (business)||Autonomy (business)||No guarantee of return (investor)||Less leverage (investor)|
|KISS||Configurable Terms(business)||Guaranteed rate of return (investor)||Less leverage (business)|
|REG A+||Publicly Reported (investor/business)||Autonomy (business)||No guarantee of return (investor)||Publicly reported (business)|
|REG D||Publicly Reported (investor/business)||No guarantee of return (investor)||Publicly reported (business)|
Many startups pick Crowd SAFEs and SAFE notes – Tallyfy did!
After conducting research into the opportunities and alternatives for raising money, Marisa and Kyle went with offering a Crowd SAFE.
With a little luck and a lot of hard work, they will solve a real problem and build a supportive investor community! Tallyfy did this too.
Republic.co (an early stage fundraising platform designed for accredited and non-accredited investors alike) created the Crowd SAFE.
Note that one big advantage of the Crowd SAFE is that it also serves as a great opportunity to market your company. Early customers love being early investors too!
More links and references to SAFE notes and private investments
SAFE notes – https://www.ycombinator.com/documents/
KISS notes – https://500.co/kiss/
Crowd SAFE notes – https://republic.co/learn/investors/crowdsafe
Startup Failure Rates – https://link.medium.com/ejSkD6WMy4
If you’re reading this post – chances are you’re …
- A founder or involved in a startup that needs to scale. If you’re thinking about raising money – we advise you think about scaling your operations too using Tallyfy.
- An early stage investor. We’ve done both SAFE notes and Crowd SAFEs at Tallyfy.
- An interested party for other reasons.
We hope you enjoyed this post!