Is a SAFE note a debt or equity?
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SAFE notes are classified as equity on the balance sheet until conversion – learn about how to account for SAFE notes.
Most importantly, unlike convertible notes, SAFE notes are not a loan or a debt instrument. This means that they lack a defined maturity date or interest rate.
A note is a debt security obligating repayment of a loan, at a predetermined interest rate, within a defined time frame. Notes are similar to bonds but typically have an earlier maturity date than other debt securities, such as bonds.
Is a convertible note debt or equity? Convertible notes are originally structured as debt investments, but have a provision that allows the principal plus accrued interest to convert into an equity investment at a later date. This means they are essentially a hybrid of debt and equity.
Instead, a SAFE note represents a right to purchase equity in the company at a future date, typically when the company raises its next round of financing or goes public. As a result, investors typically expect companies to classify SAFE notes as equity on their balance sheets.
SAFE note, also known as a Simple Agreement for Future Equity, is a type of investment contract commonly used by startups to raise capital from early-stage investors. With a SAFE agreement, you can secure funding for your startup while offering investors the right to convert their investment into equity in the future.
As we mentioned above, SAFEs punt on most governance and investor rights until the first equity round, at which point the lead investor will likely have a bigger check size and therefore more leverage and requirements By punting on these rights in an early SAFE round, you lose the opportunity to set doc precedent with ...
Early-stage funding rounds can also lead to significant equity dilution for founders. SAFEs can be structured to lower this dilution compared with traditional equity financing, enabling founders to keep more control over the company. Unlike convertible notes, SAFEs are not debt instruments and don't accrue interest.
The SAFE is legally a contract of the issuer, constituting an agreement to issue equity in the future at a purchase price paid in advance. It is not debt and, unlike a convertible promissory note, accrues no interest and has no maturity date.
Are notes considered debt?
A note is a debt security that obligates issuers to repay the creditor the principal amount of the loan and any interest payments within a defined time frame.
Equity securities are financial assets that represent shares of a corporation. Debt securities are financial assets that define the terms of a loan between an issuer (borrower) and an investor (lender).
"Debt" involves borrowing money to be repaid, plus interest, while "equity" involves raising money by selling interests in the company. Essentially you will have to decide whether you want to pay back a loan or give shareholders stock in your company.
SAFE notes do not typically accrue interest. They are not convertible debt instruments so they do not carry an interest rate, which makes them more favorable for startups as it reduces financial burdens.
A SAFE is basically a convertible note that, in an attempt to simplify, has eliminated the interest and maturity components. With a SAFE, the sole value to the investor is the company's shares which the investor receives when the invested cash converts upon a particular event.
In recent years, SAFEs have become the most common convertible instrument due to their relative simplicity. Like convertible notes, SAFEs convert into stock in a future priced round. Unlike convertible notes, they are not debt and do not require the company to pay back the investment with interest.
Generally, when a company receives funds from a SAFE note, the journal entry would be as follows: Debit “Cash” (an asset account) to reflect the inflow of funds from the investor.
SAFE Note Example
For example, an investor purchases a SAFE note from your startup with a valuation cap of $10M. Your company's value is set at $20M at $10/share during the subsequent funding round. The SAFE note will convert based on the valuation cap of $10M.
If a SAFE note never converts, the investors who provided funding through the SAFE will not receive any equity in the company. The terms of the SAFE will typically specify what will happen in this situation, but in most cases the investors will simply lose the money they invested through the SAFE.
- Risky investment: SAFE notes aren't a debt instrument and may not turn into equity.
- Requires incorporation: SAFE notes are only offered to incorporated companies, specifically limited liability companies, or LLCs.
What are the downsides of SAFE notes?
However, there are also some disadvantages to using SAFE agreements, such as being less familiar and accepted than convertible notes, diluting founder's ownership and control, creating uncertainty for the investor, and complicating the cap table and subsequent funding rounds.
Because SAFEs are relatively easy to draft and negotiate and you don't need to pay interest on them, they are a flexible way to raise funds. They are considered more founder-friendly than convertible notes as they do not have to be repaid if the venture is unsuccessful.
The SAFE is not considered an equity issuance or ownership in the company. Proceeds from investors are simply considered a liability on the company's balance sheet, and there is no taxable event at this stage.
At the time of the financing the SAFE will convert into equity of the issuer after taking into account any early-stage incentives (i.e., caps or discounts) relative to the price paid by the new (priced round) investors.
A SAFE is an agreement to provide you a future equity stake based on the amount you invested if—and only if—a triggering event occurs, such as an additional round of financing or the sale of the company.
