What Happens to SAFE Notes in Different Scenarios?

SAFE notes are one of the most flexible and commonly used tools in the early financing of startups. However, with different scenarios, the terms, and even the outcomes, related to SAFE notes differ a great deal. Knowing some of these situations helps both the startup and investor traverse through the complexities of SAFE notes and their impacts on equity and ownership. Here is what happens with SAFE notes in different scenarios.

1. Conversion In Case of a Priced Equity Round

Scenario:

SAFE notes convert into equity at the next priced equity round (the next time the company’s stock price is set).

What Happens :

• Equity Conversion: The SAFE will automatically convert into equity upon a specified event, according to the terms of the agreement, which may include a valuation cap or discount rate.

• Valuation Cap and Discount Rate: In the event that the valuation cap is lower than that of the company during the equity round, then that price is what gets embedded into the SAFE conversion. Otherwise, the discount rate offers a reduced share price.

• Ownership Stake: The SAFE notes convert to shares for investors, with the ownership percentage being at the discretion of the conversion terms.

Impact:

• Founders: Dilution will take place through additional shares given to SAFE investors at new rounds. The extent of the dilution derives from the relative size of the SAFE round to the total size of outstanding shares. 

• Investors: They get equity in the company at great prices and might receive a bigger share of ownership if the valuation cap is used.

2. Acquisition of the Company

Scenario:

Acquisition of the startup occurs before the safe notes convert into equity.

What Happens:

• Conversion to Equity: Usually, SAFE notes convert to equity at the time of acquisition, subject to terms—usually at the valuation cap or the discount rate.

• Cash or Equity Settlement: Alternatively, SAFE notes will convert immediately before the closing of the acquisition, or they may be paid in a cash or equity settlement, based on the aspects of the acquisition agreement.

Impact:

• Founders:  Impact depends on how acquisition terms handle SAFE notes. If they get converted to equity as part of this buyout, then the founder will face dilution based on the newly issued shares.

• Investors: They could benefit from this acquisition by using the shares of an acquiring company or through a cash-out. They realize a gain in value from their investment, depending on the acquisition terms.

3. Company Bankruptcy or Liquidation

Scenario:

One where the startup goes bankrupt or is liquidated before SAFE Notes are converted to equity.

What Happens:

• Liquidation Preference: Holders of SAFE notes typically have no preference to other creditors, and therefore at liquidation, they may only be repaid if there is a remaining balance after the satisfaction of all debts and shareholders with preferred equity.

• Equity Conversion: If the company liquidates prior to converting SAFE notes to equity, as an investor, one could literally get nothing in equity or otherwise for the investment.

Impact:

• Founders: The bankruptcy or liquidation affects the founders adversely due to the possible loss of equity in case the firm fails.

• Investors: In case the startup’s assets are inadequate to cover all its liabilities and obligations, they may receive very little or nothing out of their investment.

4. Further Funding Rounds

Scenario:

Subsequent funding rounds occur after the issue of SAFE notes but before their conversion to equity.

What Happens:

• Conversion Impact: Additional SAFE notes or equity rounds may further dilute the ownership percentage of previous SAFE investors. While this doesn’t affect the actual terms for a holder of original SAFE notes, but it does complicate the cap table in total.

• Dilution Management: How further funding rounds affect SAFE note holders depends on how their conversion terms interact with new financing rounds.

Impact:

• Founders: A new funding round is most likely to bring about increased dilution to the founders and early investors, including SAFE note holders. 

• Investors: When new funding rounds issue more shares, SAFE note holders can experience diluted ownership percentages. However, the impact depends on the terms of their individual SAFE notes and the valuation at each round.

5. Conversion Triggered by a Qualifying Financing Event

Scenario:

SAFE notes are event-specific. They convert upon the occurrence of specific events, such as a large strategic partnership or milestone reached, or any other agreed-upon terms.

What Happens:

• Trigger Conversion Event: SAFE notes automatically convert to equity if a certain event, as outlined, occurs. This can occur prior to the occurrence of a qualified financing round.

• Equity Allocation: The equity allocation shall be done based upon terms such as valuation cap or discount rate as noted in the SAFE note.

Impact:

• Founders: The short-term effect can be dilution, but equity conversion can be designed on key strategic milestones appropriate to the company’s growth and valuation. 

• Investors: They would receive equity on the most favorable terms under the SAFE notes, perhaps even setting them up to benefit from the hitting of important milestones.

Conclusion

SAFE Notes in Different Scenarios offers flexibility and a founder-friendly approach to early-stage financing, but their impact can vary depending on the situation. Whether during a priced equity round, acquisition, or bankruptcy, the conversion of SAFE notes influences how equity is distributed, altering ownership stakes for both founders and investors. Understanding these different scenarios is crucial for startups and investors to make informed decisions about financing strategies involving SAFE notes.