This blog series has been primarily focused on HOW to raise money, or at least increase your chances. In this article I want to focus on the actual instrument you will use to raise that money, which in most cases is a SAFE note. SAFE notes are things that venture capital firms deal with all the time, but for first time founders, they can easily get confused on the different parts and terms. Let's take a deeper look at SAFEs so you can understand everything you need to know.
What is a SAFE Note? Discount? Cap?
SAFE stands for Simple Agreement for Future Equity. A SAFE note is a legally binding agreement that allows an investor to buy shares for an agreed upon price at some point in the future, which is usually a subsequent funding round. SAFE notes are not debt instruments so they have no interest and due date. Some firms prefer to issue debt with an interest rate and due date that converts into equity. These are called convertible notes instead of SAFEs. Both of these work almost entirely the same, they give the investor shares of your company, in the future.
A discount is a term in the SAFE that allows investors to buy shares at a reduced price. So for example if you have a SAFE with a 20% discount and then raise money for $1.00 per share, the investors from your SAFE note can buy shares at $0.80 per share. The SAFE investors get more for their more since they took a chance on your company earlier on.
On the other hand a cap places a ceiling on a startups valuation in the next round. Let's say you raise $1M on a SAFE with a $5M cap. However, in the next round you raise an additional $1M at a valuation of $10M for the same $1.00 per share as above. Your second investor would receive 1M shares for the $1M they gave you. Your first investor also gave you $1M so you might think they also get 1M shares, but this investor had a $5M cap on their SAFE. Since your first investor had a cap at half of the value of the company, they actually get 2M shares for their $1M. The cap is upside protection your early investors and gives them more shares (double in this case) because they get rewarded for taking the early risk.
Where Should You Set the Cap?
Now that you understand how SAFEs work, let's talk about where you should set your cap. The answer for startups is to set the cap as high as possible so you can avoid giving away large chunks of your company in future fundraising rounds. If you believe that you can get a $5M valuation in your next fundraising round, then don't set the cap on your SAFE at $1M, because you will have to give up 5 times the shares to that investor if you do end up raising that next round at $5M. Setting low caps and getting free shares is a away that investors can take advantage of startups. Don't be uninformed and let them take huge chunks of shares away from your business.
Summary
SAFEs allow investors to buy shares in your company at a some point in the future, typically your next fundraising round. Discounts provide a reduced share price for early investors while caps set a ceiling on your company's valuation. As a founder always try to set the cap as high as you can and to a valuation you believe you can raise to in your next round. Don't be fooled by investors that try to set an extremely low cap, they are just trying to take more of your business. If you want more advice on how to raise money on a SAFE, reach out to us at InfleXion Point. We are happy to help!
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