Updated: Aug 7
Are you an aspiring startup founder looking for the right funding path? Or perhaps an investor who is curious about different investment instruments in the startup ecosystem?
Choosing the right funding path is a critical decision that can impact the future of your startup.
Two popular options in the startup funding landscape are SAFE (Simple Agreement for Future
Equity) and convertible notes. While both offer unique advantages and considerations, understanding their differences is key to making an informed choice.
In this article, we will dig into the complexity of SAFE and convertible notes, exploring their structures, conversion mechanisms, key terms, advantages, drawbacks, and when to use each option.
Whether you're a founder seeking funding or an investor seeking opportunities, join us on this journey as we explore the dynamics of SAFE vs. convertible notes and help you navigate the path to startup success.
What is a SAFE?
SAFE stands for Simple Agreement for Future Equity. It is a financial instrument commonly used in startup funding rounds, particularly in early-stage investments.
The SAFE was created by Y Combinator, a famous tech accelerator located in Silicon Valley, California.
It offers an alternative to conventional seed-stage financing plans, which employ convertible notes or preferred shares.'
How does a SAFE Work?
SAFE is an agreement between a firm and an investor that gives the investor the right to purchase ownership in the company at a later time, generally after the achievement of a certain milestone or a future funding round.
In contrast to conventional equity financing, a SAFE does not instantly provide the investor with ownership or stock in the company. Instead, it signifies a commitment to do so when a certain triggering event, such as a priced equity round or a liquidity event, occurs in the future.
Although the specifics of a SAFE's terms and conditions can vary, they typically outline the trigger events, the valuation cap (the highest price at which the investor's ownership will be determined), and sometimes an investor discount rate.
In the event that the company dissolves before a future equity funding round, the SAFE investor will be given priority in receiving her investment back over other shareholders. Usually, the SAFE investor has a 1x liquidation preference.
Conversion rights may also be possible. In other words, the SAFE investor can convert her SAFE investment into common shares (rather than a future class of preferred shares) in the case of an acquisition or IPO. Common shares are normally valued according to the valuation cap that will apply to the next equity funding event.
Key terms associated with a SAFE note
SAFE notes come in several different options, including:
Valuation cap but no discount: This type of SAFE note sets a maximum valuation at which the investor's investment will convert into equity, but it does not include a discount on the conversion price.
Discount but no valuation cap: In this case, the SAFE note includes a discount on the conversion price, which allows the investor to purchase equity at a lower price per share compared to future investors. However, there is no maximum valuation set.
Valuation cap and discount: This option combines both a valuation cap and a discount. The investor benefits from a discounted conversion price and also has a maximum valuation at which their investment will convert into equity.
No valuation cap or discount: This type of SAFE note does not include a valuation cap or a discount. The investor's investment will convert into equity at the same terms as future investors during a subsequent equity financing round.
Most Favored Nation (MFN) status: With MFN status, early noteholders are granted the right to receive the provisions included in later SAFEs. If future SAFE notes have more favorable terms, the early noteholders can request to have those terms applied retroactively to their investment.
Pro rata rights: Pro rata rights give investors the option to invest additional funds in subsequent
equity financing rounds to maintain their ownership percentage in the company. This allows investors to protect their ownership stake as the company raises more capital.
What is a convertible note?
A convertible note is a type of debt instrument commonly used by early-stage startups to raise funds. It is a form of short-term debt, an interest-bearing loan offered to companies, that has the potential to convert into equity at a later date, typically during a future financing round or event.
How does the Convertible note work?
Generally, one year from the date of the loan or the maturity date, the investor will either get a balloon payment on the note or be given the option to convert it into preferred shares as part of a subsequent equity fundraising event.
The company's valuation at the time the convertible note was signed is not stated in the document. The future conversion of the note into preferred shares will be based on the valuation of a future financing event.
A value cap that sets a maximum price that can be paid for the preferred shares by the convertible note's owner is included in the note. Additionally, the note typically permits future investors to purchase preferred shares at a reduced price.
Convertible notes offer flexibility for both the company and the investor. For the company, they provide a way to secure funding without immediately determining a valuation or diluting existing shareholders. For investors, they offer the potential for equity participation in a company's future success while providing some downside protection through the debt component.
Key terms associated with a convertible note
Convertible note agreements typically include the following terms:
Valuation Cap: The valuation cap is the maximum pre-money valuation at which the convertible note will convert into equity. It sets an upper limit on the valuation used to calculate the conversion price of the note. If the subsequent financing round results in a valuation higher than the cap, the note converts at the cap price.
Discount Rate: The discount rate is the percentage discount that the investor receives compared to the price per share paid by future investors in the next equity financing round. It provides an incentive for early investors by allowing them to convert their notes into shares at a lower price than later investors.
Interest Rate: The loan amount on the convertible note accumulates interest, represented by the interest rate. However, instead of being paid back in cash, the interest is typically converted into equity when the note converts. The interest rate ensures that the investor receives additional equity as compensation for the time value of their investment.
Maturity Date: The maturity date is the date by which the convertible note must be repaid if it hasn't been converted into equity before then. Typically, if the note is not converted by the maturity date, the issuer is obligated to repay the principal amount along with any accrued interest.
When to use a SAFE vs. convertible note
The startup's unique needs and circumstances will determine if a SAFE or a convertible note is the best option.
For advice on which choice best fits your objectives and the preferences of potential investors, you should speak with legal and financial experts like us at Compass CPA, PC.
To get a better idea of which type of investment is right for you, consider the key differences between the two:
Trigger Event and Conversion Terms: SAFEs have a single specific trigger event that determines when they convert into equity. In contrast, convertible notes offer several possible conversion terms, providing more flexibility but also requiring negotiation.
Complexity and Points of Negotiation: SAFEs are generally simpler than convertible notes, with fewer points to negotiate. They provide a straightforward mechanism for future equity conversion, whereas convertible notes may involve the negotiation of interest rates, maturity dates, valuation caps, and discounts.
Legal Requirements and Fees: Issuing a SAFE typically requires less legal input and fewer fees compared to a convertible note. The documentation for SAFE agreements is often available for free on Y Combinator's website. Convertible notes, on the other hand, may involve more time and legal expenses to create the necessary documentation.
Maturity Date and Flexibility: SAFEs do not have a maturity date, giving startups more time to achieve milestones and objectives before the agreement converts into equity. This flexibility can be beneficial for startups that require additional time to grow and attract further investment. Convertible notes, however, usually have a maturity date, at which point they must either be repaid or converted into equity.
Investor Familiarity: Convertible notes have been in use for a longer time and are more familiar to investors, particularly those outside of Silicon Valley. This familiarity can make it easier for startups to attract investment from a wider range of investors who are accustomed to convertible notes as an investment instrument.
Differences between SAFE vs. Convertible Note vs. Equity
SAFE, convertible notes, and equity represent different forms of investment instruments. Here are the key differences between them:
Structure: SAFEs and convertible notes are both debt-like instruments that convert into equity, whereas equity represents ownership directly.
Timing of Conversion: SAFEs typically convert upon a specific trigger event, while convertible notes convert upon a predefined event or maturity date. Equity represents immediate ownership upon purchase.
Interest and Maturity: SAFEs do not accrue interest or have a maturity date, while convertible notes accrue interest and may have a maturity date when the loan must be repaid if not converted. Equity does not involve interest or maturity.
Negotiation: SAFEs generally involve fewer negotiation points compared to convertible notes, which often require discussions on interest rates, conversion terms, and other terms of the loan. Equity investments may involve negotiations on the valuation and terms of the ownership stake.
Legal and Documentation: SAFEs often have standardized documentation available for free, while issuing convertible notes typically requires more time and legal fees. Equity investments involve legal agreements such as share purchase agreements and shareholder agreements.
Investor Rights: Convertible notes and equity investments usually come with specific rights and protections for investors, such as voting rights and information rights. SAFEs may have simpler terms and fewer investor rights.
Benefits and Drawbacks of SAFE vs. Convertible Notes
Advantages of SAFEs (Simple Agreement for Future Equity):
No interest or repayment: SAFEs do not incur interest or require repayment, unlike traditional loans. This relieves the financial burden on the company and provides flexibility in managing cash flow.
Reduced threat of insolvency: Since SAFEs are not considered debt, they do not appear as liabilities on the balance sheet. This reduces the risk of insolvency and can be advantageous for startups with limited resources.
Simplicity and cost-effectiveness: SAFEs are generally simpler and cheaper to negotiate compared to convertible notes. They do not involve maturity dates or interest rate terms, making the negotiation process more streamlined.
Indefinite timeline: SAFEs do not have a maturity date, allowing them to remain in the background until the company is ready for the next funding round. This provides flexibility and eliminates the need to define a specific conversion trigger.
Retained control: Both SAFEs and convertible notes allow the company founders to retain control of the company during the early growth phase. Equity issuance is deferred, allowing founders to maintain decision-making authority.
Deferred valuation and tax implications: By using SAFEs or convertible notes, startups can defer questions of valuation until a later stage, when the company has established trading history. This also helps avoid immediate tax implications related to equity issuance.
Advantages of Convertible Notes:
Negotiation efficiency: Convertible notes may require more negotiation upfront, but once the terms are established, they can be easily rolled out to multiple investors. This saves time and effort in negotiating individual terms for each investor, as seen with SAFEs.
Market testing and adjustments: The individual negotiation of convertible notes allows founders to test the market and make adjustments to the terms as needed. This flexibility can be beneficial for startups seeking investor interest and feedback.
Established funding method: Convertible notes have been used as a funding method for a long time and have a track record of reliability. This familiarity may attract investors who are more comfortable with this established instrument.
Reduced investor risk: Convertible notes are considered debt, accruing interest, and obligating repayment. This reduces the risk for investors compared to SAFEs, as they have a legal claim on the repayment of the loan.
Liquidation preference: Both SAFEs and convertible notes can provide holders with a liquidation preference. This means that in the event of company liquidation, note holders are prioritized in receiving their investment back before other shareholders.
Disadvantages of SAFEs:
Dilution and impact on future funding: SAFEs may lead to dilution waterfalls or a multiplier effect, where large percentages of the company are effectively given away in advance of future funding rounds. This can negatively impact the company's ability to raise money in subsequent rounds and may result in lower valuations.
Limited investor comfort: SAFEs are a relatively new funding method, and some investors may not be familiar with or comfortable with them yet. This could make it challenging for founders to attract the desired number or type of investors.
Riskier investment for investors: SAFEs, unlike convertible notes, do not have an obligation to repay, a maturity date, or interest. This makes them riskier for investors, particularly at the early funding stage. The absence of repayment obligations may deter certain investors from participating.
Disadvantages of Convertible Notes:
Potential debt-related issues: Convertible notes, being debt instruments, carry the risk of default and potential bankruptcy if the company fails to meet repayment obligations. This can create stress for founders and lead to cash flow challenges.
Dilution of ownership: When a startup raises funds through convertible notes, they typically convert into equity at a later financing round. This conversion often results in the issuance of new shares, leading to a dilution of ownership for existing shareholders, including founders and early investors. The more convertible notes that are issued, the greater the dilution effect.
Uncertain valuation: Convertible notes delay the valuation of a startup until a subsequent financing round when a conversion occurs. This can make it challenging to determine the precise value of the company, as the valuation depends on future negotiations and market conditions.
Consequently, both investors and founders may find it difficult to agree on a fair conversion price, leading to potential conflicts.
Limited investor rights: Unlike equity investors, convertible note investors often have limited rights and protections. Until conversion occurs, they may not have the same level of control, voting rights, or information rights as equity holders. This limitation can leave investors with less influence over company decisions and less visibility into the startup's operations.
It's crucial to remember that the benefits and drawbacks listed above are broad factors and that each startup and investor may have different needs and preferences. It is wise to get the advice of legal and financial experts to choose the best funding option for your circumstances.
Additional factors to consider when using SAFEs or convertible notes
Protection against dilution
Anti-dilution protection is a mechanism designed to protect investors from dilution of their ownership stake in a company during future financing rounds. It ensures that early-stage investors, who often invest at a lower valuation, are not unfairly diluted when subsequent rounds of funding take place at higher valuations.
Valuation Cap: A valuation cap is a common feature in convertible notes and Simple Agreement for Future Equity (SAFE) instruments. It sets a maximum valuation at which the investor's investment will convert into equity when the next financing round occurs. If the valuation of the company in the subsequent round is higher than the valuation cap, the investor's conversion price is based on the lower valuation cap, providing them with a better price per share compared to the later investors. This protects the early-stage investor from excessive dilution.
Most Favored Nation (MFN) Clause: In addition to the valuation cap, some convertible notes and SAFEs may include an MFN clause. This clause ensures that if the company offers more favorable terms to subsequent investors (e.g., lower valuation, additional rights, or benefits), the original investor has the right to benefit from those terms as well. Essentially, the investor will have the option to amend their original investment terms to match those offered to subsequent investors, ensuring fairness and equal treatment.
Understanding the possible dilution effect and negotiating advantageous terms with early-stage investors are crucial for founders. Founders can assess the effect on their ownership position and decide wisely about valuation caps and other terms by assessing the possible dilution in future financing rounds. For the best protection and negotiating tactics, it is advisable to contact legal and financial experts with startup finance experience.
Preferences during liquidation
Liquidation preferences are provisions commonly found in investment agreements like convertible notes or preferred stock. They determine the order of distribution of proceeds in the case of a company's liquidation. Valuation caps on convertible notes or SAFEs can create a discrepancy between the original note price and subsequent investor prices, affecting liquidation preferences.
Typically, without additional protections, note holders' liquidation preference is based on the original price, which may be lower than subsequent investors' prices. This means noteholders would receive a higher return on their investment during a liquidation. To address this, provisions can be included to limit note holders' liquidation preference by issuing parallel preferred shares reflecting the actual price paid by note holders.
This aligns the liquidation preferences of note holders with those of subsequent investors, ensuring a fair distribution of proceeds. It's important to note that specific terms can vary based on agreements, negotiations, and applicable laws. Consulting legal and financial professionals is advisable for tailored guidance.
How can startup founders make a decision between SAFEs and convertible notes?
The provided text discusses the differences between convertible notes and Simple Agreement for Future Equity (SAFE) in the context of seed investments. Here is a summary of the main points:
SAFE is simpler and more streamlined compared to convertible notes, with only a 5-page document and no interest rate or maturity date.
Conversion to equity: Convertible notes allow conversion into the current or future financing rounds, while SAFE only allows conversion into the next financing round. SAFE also converts upon raising any amount of equity investment.
Valuation cap: Both instruments can have a valuation cap, but caution is advised as entrepreneurs may end up with less ownership due to dilution when the notes convert to equity.
Early exit: Both convertible notes and SAFE offer payout mechanisms in the event of an acquisition or IPO. SAFE provides the choice between a 1x payout or conversion into equity at the cap amount.
Interest rate: SAFE does not carry an interest rate, while convertible debt typically has an interest rate ranging from 2% to 8%.
Maturity date: Convertible notes have a maturity date, which can pose challenges if the company cannot pay back the principal and interest. SAFE, being a non-debt instrument, does not have a maturity date.
Administration fees and services: It is debatable whether a SAFE triggers the need for a fair (409a) valuation, potentially saving costs associated with professional services.
Overall, SAFE offers simplicity, but convertible notes provide more control to entrepreneurs and may be preferable in certain situations.
When choosing between a SAFE (Simple Agreement for Future Equity) and a convertible note for startup funding, it's important to consider the startup's specific needs and circumstances.
SAFEs offer simplicity, cost-effectiveness, and flexibility, while convertible notes provide negotiation efficiency, market testing opportunities, and familiarity to investors.
Factors such as trigger events, conversion terms, legal requirements, and investor rights should be considered. Additionally, protection against dilution and preferences during liquidation should also be taken into account.
Ultimately, founders should consult with legal and financial experts to make an informed decision based on their startup's circumstances and investor preferences.