SAFE Notes Explained: Definition, Calculations, Excel Examples, and Whether They’re “Unsafe” for Startups

In this tutorial, you’ll learn about “SAFE Notes” for investing in startups, how they compare to traditional priced equity rounds, and whether they’re actually “unsafe” for startups.

SAFE Notes Definition: With SAFE Notes (“Simple Agreement for Future Equity”), startup investors contribute capital but do not receive direct ownership in the startup right away; instead, they receive their shares later, when the company raises its first “priced round” based on a specific investment amount and agreed-upon valuation.

With SAFE Notes, just like with convertible notes, the startup co-founders and the investors do not necessarily need to agree on a valuation or many other terms that are part of the standard term sheet.

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However, SAFE Notes may also create long-term problems for startups because of disputes about future ownership and how to handle their conversion into shares.

Also, in many cases, SAFE Notes do set an effective valuation via a “valuation cap,” and they can create awkward situations if the startup fails because they are “in-between” traditional debt and equity.

You can get our simple SAFE Notes Excel model and presentation slides and read this entire tutorial in written format below:

SAFE Notes – Excel Model (XL)

SAFE Notes – Presentation Slides (PDF)

Video Table of Contents:

1:54: Part 1: SAFE Notes in a Seed Round

3:26: Part 2: Conversions in the Series A (Caps and Discounts)

8:54: Part 3: How an Options Pool Makes It Even Worse

10:32: Part 4: Are SAFE Notes Worth It?

12:39: Recap and Summary

Part 1: SAFE Notes in a Seed Round

If a startup raises capital via SAFE Notes in a Seed Round, nothing changes with the capitalization table (“cap table”) because the investors do not receive direct ownership.

So, if two groups invest $2 million via SAFE Notes, and the co-founders own 90% with the employees owning 10%, the ownership percentages remain 90% and 10% after the deal:

SAFE Notes in a Seed Round There are terms associated with these SAFE Notes – namely the valuation cap and conversion discount – but these only take effect in the next priced round, when the startup raises capital at a specific valuation.

Also, unlike with venture debt, no warrants are initially issued to the SAFE investors, and no cash interest rate or ongoing fees are attached.

Part 2: SAFE Note Conversions in a Series A Round (Valuation Caps and Conversion Discounts)

We’ll assume here that this startup plans to raise $5 million at a $10 million pre-money valuation.

That means the post-money valuation is $5 + $10 = $15 million, so the VC firm expects to own ~33% of the company:

SAFE Notes in a Series A Round

But this is not what happens in reality! The VC firm investing $5 million in this Series A will own less than 33% because of the shares that go to the SAFE Note investors.

Here’s the step-by-step process to calculate the ownership:

Step 1: Calculate the “Price per Share” in the Series A Round

This is based on the pre-money valuation divided by the Pre-Money Share Count (the shares that existed before the Series A):

Series A Price per Share Calculation

It’s $7.50 here, which means the Series A investors pay $7.50 for each new share they purchase in this round.

Step 2: Determine the “Price per Share” for the SAFE Note Investors

This is where the conversion discount and valuation cap come into play.

If there’s a conversion discount, the SAFE Note investors get their shares at a discount to the $7.50 the Series A investors pay:

Conversion Discount with SAFE Notes

If there’s a valuation cap, the SAFE Note investors get their shares at a price equal to the Valuation Cap / Pre-Money Shares:

Valuation Cap for SAFE Notes

Step 3: Calculate Each Group’s New Shares in this Priced Round

The next step is to calculate the shares each group purchases or receives in this round based on the amounts they invested divided by their effective share prices:

SAFE Note Investors' Share Conversions

The valuations are based on the $7.50 overall share price in this round, times the number of shares each group has.

Step 4: Link in the Post-Series A Cap Table and Calculate the Ownership Percentages

Immediately after this Series A round, 1.33 million + 0.967 million shares = 2.3 million shares are outstanding.

We assume that the 133,333 options owned by the employees stay the same.

Based on this new total share count, we can calculate each group’s ownership and share value:

Series A Cap Table After SAFE Note Conversions

The Series A investors own less than 33% because the Seed Investors got their shares “for free” in this round based on their previous investment.

Therefore, the “true” Pre-Money Valuation was higher.

If we recalculate it based on the $10 million plus the value of the shares granted to the SAFE Note investors in this round, we get the Series A investors’ ownership:

Series A "True" Pre-Money Valuation and Ownership

Because of this issue, people have developed different ways to determine the number of shares that SAFE Notes convert into.

For example, they might use the “Dollars Invested” method, a weighted average of the share prices, or another method to find a middle ground between the investor groups.

However, since the exact method is not always spelled out in the investment term sheets, this point sometimes turns into a conflict or heated debate between the SAFE Note and Series A investors.

Part 3: How an Options Pool Complicates SAFE Notes Even More

We assumed in this simple example that the employee options remained the same at 133,333.

But this options pool is usually upsized or re-sized in a priced round, such as a Series A, and that creates additional complications because now the employees effectively get “free shares.”

These free shares dilute the Series A and SAFE Note investors and reduce their ownership percentages.

To calculate the impact, start with the total non-option shares after the SAFE Note conversions and Series A funding, which are 1.2 million + 966,667 = 2.167 million in this case.

Then, divide this by (1 – Options Pool %), where the “Options Pool %” is the percentage of company shares that employees should own in the form of options:

Effect of Options Pool on Post-Series A Ownership

The employees should have 20% * 2,708,333 = 541,667 shares after this round, and they already have 133,333 options.

Therefore, they receive 541,667 – 133,333 = 408,333 additional options in this round, which count as “free shares.”

This further dilutes the Series A investors down to ~25% ownership:

Series A Investor Dilution from Options Pool Upsizing

This may not seem like a big deal, but if this startup sells for $100 million, it will mean the difference between the Series A investors getting $33 million vs. $25 million.

$33 million in proceeds is a 6.6x multiple of the initial $5 million investment, while $25 million is a 5x multiple – and this difference is significant for early-stage venture capital firms.

The bottom line is that these SAFE Note conversions, the employee options pool, and anything else that creates “free shares” significantly impact VC investors in any startup deal.

That’s why startups cannot afford to ignore these points and must be precise with their investment term sheets’ language and conversion methods.

Part 4: Are SAFE Notes Worth It?

When SAFE Notes were introduced in 2013, they had substantial advantages over “priced equity.”

Back then, priced rounds were much more expensive, requiring higher legal fees and more negotiation time.

But in the past 10+ years, the advantages of SAFE Notes have diminished.

Priced rounds have become cheaper and easier due to widely used templates and packaged services from law firms, and the disadvantages of SAFE Notes have become clearer.

For example:

  • SAFE Notes create messy cap tables and unclear ownership following a priced round because different investors sometimes disagree about the conversion methods.
  • If the Notes use a valuation cap, they effectively set a price because few VCs will want to exceed that cap in the next round. So, the startup founders may not necessarily be able to “avoid or defer” the valuation discussion.
  • If the startup fails, SAFE Note investors are in an awkward position because the notes are neither debt nor equity, so the exact treatment in a bankruptcy or liquidation is not always clear.

We believe Y Combinator and other startup incubators pushed SAFE Notes and similar instruments heavily because they knew most startups would fail before ever reaching their Series A rounds.

If that happens, SAFE Notes don’t cause any ownership issues in these next priced rounds.

So, startups retain the advantages and avoid dealing with the negative consequences later.

The startup incubator logic was simple: Get quick and cheap funding for as many companies as possible, wait for the survivors to rise to the top, and let the successful companies deal with ownership and dilution issues later.

This logic isn’t necessarily “wrong” but is quite a cynical way to approach startup investing and advisory.

After Paul Graham of Y Combinator enthusiastically introduced SAFE Notes in 2013, he faced some pushback from other well-known VCs and startup investors, such as Fred Wilson:

Paul Graham - SAFE Note Introduction in 2013

Fred Wilson - Criticism of SAFE Notes

Based on everything here, we’d give the victory to Fred Wilson.

SAFE Notes are a textbook example of making something “faster and cheaper” in the short term while creating potential long-term problems.

And if you’re operating a startup, you should usually focus on traditional priced equity rounds.

About Brian DeChesare

Brian DeChesare is the Founder of Mergers & Inquisitions and Breaking Into Wall Street. In his spare time, he enjoys lifting weights, running, traveling, obsessively watching TV shows, and defeating Sauron.