When it comes to funding early-stage start-up companies, there are two main options: SAFE (of “Simple Agreement for Future Equity”) Notes and Convertible Notes. But in the SAFE vs. Convertible Note discussion, which ultimately comes out on top?
Both SAFE and Convertible Notes have many similarities, but they also have key differences which you should be very aware of as you start have discussions with potential future investors to raise funds.
In this blog post, we will explore what SAFE and Convertible notes really are and the pros and cons of each type of security, so that you can make an informed decision about whether a SAFE or Convertible Note is best for your startup.
What is a Convertible Note?
A convertible note is a type of debt that converts to equity, usually in the event of a future priced equity round. The key advantage of a convertible note is that it allows startups to delay setting a valuation for their company.
This can be helpful in situations where the startup’s value is not yet clear, which is usually the case with an early-stage startup that may not be generating revenue yet. The reasoning is that since neither the company founders nor the early-stage investors can be sure of the startups valuation at that early stage, they will wait until the company has received a priced equity financing and convert the debt instrument into the company’s shares at that time. (Read more about How to Raise Venture Capital and Venture Capital Advantages and Disadvantages).
Why Are Convertible Notes Used in Seed Investments?
For many, many years, convertible notes were the most common method of funding pre-seed and seed stage startups, and from an investor’s perspective, convertible notes continue to be a very attractive method of investing seed money in early stage startups. (Read more about Pre-Seed Funding: What It Is and How to Get It).
Unlike equity financing (or, for that matter, SAFE notes), convertible notes are an interest-bearing loan to the company. Although the convertible notes are expected to convert to preferred stock upon the occurrence of a future financing event (usually a priced round), the convertible debt agreement will provide for a maturity date, upon which a balloon payment will be due.
This is important because if for some reason, the startup is forced to dissolve before a qualifying transaction takes place, the holders of the convertible will receive priority in getting their investment back over the company’s shareholders.
The Valuation Cap and the Discount Rate
The convertible debt agreement will also include two particularly key provisions: the valuation cap and the discount rate.
What is a Valuation Cap?
A valuation cap is a mechanism that establishes a maximum valuation to be used in calculating the price per share that the convertible note will convert into.
Even though one fo the main reasons that convertible notes are used by startups and investors is because they delay the painful process of attempting to agree on the valuation of an early stage startup, the valuation cap sets a ceiling on the valuation of the company for purposes of conversion. That valuation “ceiling” in turn establishes a “floor” on the number of shares that the investors can receive for their seed investment.
A Valuation Cap Example
For example, let’s say that a startup has issued $1 million in convertible notes with a $10 million valuation cap. And for purposes of this simple example, let’s say that the startup has 10 million shares outstanding.
If, at the time of conversion, the company’s pre-money valuation is $20 million, the convertible note holders will still be able to convert their convertible notes into preferred shares of the company as if the valuation is still $10 million.
In practical terms, instead of having to “purchase” the shares of preferred stock at $2.00 a share (10 million shares at a pre-money valuation of $20 million = $2/share), the convertible note holders will still be able to convert their convertibles notes at a rate of $1.00 a share (10 million shares at the valuation cap of $10 million = $1/share).
What’s the difference?
Because the convertible notes convert at a rate of $1 per share instead of $2 per share, the note holders receive 1 million shares instead of 500,000.
Valuation caps protect investors in the event that the company is sold or goes public at a much higher future valuation than was originally anticipated.
What is a Discount Rate?
The discount rate is another legal mechanism which ensures that early-stage investors receive a a favorable conversion rate for their investment.
The discount provisions gives early investors an automatic discount on the conversion of their convertible notes into preferred shares upon the qualifying future financing event.
So, say the convertible notes include a discount provision of 20%, and the startup is later able to rase a later funding round which results in a price per share of $5.
Because of the 20% discount, the note holders will be able to convert their notes into shares at a rate of $4 per share instead of $5, a significant difference.
For many, many years, convertibles notes were the most common method for funding early-stage startups, but recently, SAFE notes have become extremely popular with both startups and investors.
What is a SAFE Note?
Unlike convertible notes, a SAFE note is a type of security that is not debt, does not accrue interest and does not have to be repaid.
Instead, SAFE stands for “Simple Agreement for Future Equity.” Instead of being equity (i.e. shares of stock) or debt (like convertible notes), a SAFE is only a contract to purchase future equity in the startup.
History of Safe Notes
Without getting bogged down, it is worth explaining a little bit of the history of SAFE Notes.
SAFE notes were developed at the famous, Silicon Valley accelerator Y Combinator as an alternative method of providing seed funding to early stage startups, something that would simpler, cheaper, and faster than going through the process of negotiating and issuing either convertible notes or shares of preferred stock.
So instead of going to the time, trouble, and expense (i.e. legal fees) of going through a full negotiation of all the terms that would be required in a convertible note (e.g. liquidation preferences, anti-dilution measures, etc.), the SAFE investor just agrees to purchase that future equity during a future priced round.
By in effect relying on the terms of that future round, the SAFE note streamlines the process of how early-stage startups raise money, eliminating the haggling over terms which are challenging to negotiate in the best of times, let alone for a startup which is still pre-revenue and/or trying to build traction.
Because of this, SAFE notes have become especially popular with pre-seed investors like angel investors and in friends and family rounds, where the investors are individuals investing their own money, and would prefer to bypass the expense of legal counsel.
SAFE vs Convertible Note: Valuation Caps and Discounts
Startups using SAFE notes don’t get to bypass all negotiation, though, and there are still some terms that will likely need to be worked out.
Most importantly, the valuation cap and the discount. Even though investors may be willing to take a “wait and see” approach to many terms by using SAFE notes, valuation caps and discounts are still very common negotiated terms in most SAFE notes.
SAFE investors take a major risk in an early stage startup, and they expect to be compensated for that risk. By including a valuation cap and discount rate in the SAFE note, they’re rewarded for investing in the startup early, before the new investors.
SAFE Notes and the Financing Threshold
Another provision that may be negotiated in a SAFE note is the financing threshold that triggers the SAFE note’s purchase of future equity.
One of the downsides of SAFE notes from an investor perspective is because they are so quick and easy to issue, a startup could possibly go through several future funding rounds of SAFE notes before reaching a fully-negotiated funding round.
To protect against that possibility, many SAFE notes include a provision for a minimum financing threshold to trigger that purchase of future equity and the terms that go along with it.
SAFE Notes and MFN
Another provision that is likely to be included in a SAFE note that startups should be aware of is the “Most Favored Nation” (or “MFN”) provision.
If an MFN is included, a startup will be required to offer the holder of the SAFE note the chance to amend its SAFE note to match the terms of any SAFE notes that come later.
So for example if the early investors agree to SAFE notes that include a very high valuation cap (or in some cases, no valuation cap at all), but include an MFN, but new investors come along, and negotiate a very favorable valuation cap, because of that MFN, the early investors will have an opportunity to amend their SAFE notes to include that later valuation cap.
SAFE vs Convertible Note: So What’s the Bottom Line?
So a bunch of you out there are probably thinking, “Dude! I just need to raise cash! What’s the bottom line on a SAFE vs. Convertible Note?”
SAFE notes are definitely going to be the fastest, cheapest and easiest investment vehicle for you use to raise money as an early-stage startup. The legal costs of setting up SAFE notes is much, much lower than setting up convertible notes or funding rounds of preferred shares. And they are popularly used with many pre-seed funding investors (friends and family, angel investors, etc.).
SAFE notes can also be simpler investment vehicle because the Y Combinator form for a SAFE Note is considered standard, so there tend to be few deviations from the Y Combinator form, other than for the terms of the valuation cap, discount, financing threshold and MFN provisions. In some cases, convertible notes may potentially conflict with a businesses other obligations.
However, SAFE notes are not without their drawbacks which are worth noting…
Drawbacks to SAFE Notes
Despite their popularity, SAFE notes are not without their drawbacks, and they should be carefully considered. (In other please, don’t be the startup who downloads the Y Combinator form and starts issuing SAFE notes willy-nilly to every investor off the street!).
And it’s always worth noting that in evaluating the SAFE vs. Convertible Note pros and cons, some investors are just more comfortable with convertible notes.
SAFE Notes and Maturity Dates
Reminder: SAFE Notes are only an agreement to purchase future equity. They’re not actually equity, nor are they a debt instrument, so there is no maturity date on a SAFE note (vs. convertible note).
Unlike convertible notes which have a maturity date upon which they become due and payable (in cash or conversion), theoretically, SAFE notes could be hanging out there indefinitely. Forever.
SAFE Notes and Counsel
Because SAFE notes are SO easy to work with, there is very much the danger of founders skimping on legal advice when taking SAFE note investment.
No one says that legal services are cheap! And sometimes lawyers can be annoying, but before you run off and start downloading a SAFE note form off the internet and going to town, seek some professional legal advice to avoid common pitfalls that overly-eager founders can find themselves in. Common pitfalls can include agreeing to an overly generous discount or issuing SAFE notes with inconsistent terms which can turn into a nightmare when they all need to be converted with your later funding round.
SAFE Notes and Your Cap Table
Related to that, before you jump into a SAFE note with any investor, you should carefully consider how it will convert and how it may affect your cap table.
It’s way, way, way too common for founders of early stage companies to issue SAFE notes without fully understanding how they will eventually convert into shares of their company. Is the conversion on a pre-money valuation basis? A post-money valuation basis?
Too often founders are unpleasantly surprised by the conversion when that equity round finally happens, so before you issue any SAFE notes, it’s important to understand how that conversion mechanism will work and how it will be represented on your cap table.
In an attempt clarify some of the confusion around conversation, Y Combinator’s more recent SAFE Note forms specify “Post-Money Valuation” SAFE note, where “Post-Money Valuation” refers to Post-SAFE Money but Pre-Equity Round.
Alternatives for Pre-Seed and Seed Funding
Even though SAFE Notes and Convertible Notes are the most common vehicles startups to raise money, they’re not for everybody and, in the SAFE vs Convertible Note discussion, they are not the only options out there!
If you’re looking for alternatives, there are a few other options to consider. One increasingly popular option is to raise money through crowdfunding, that is raising small amounts of money from a large number of people. Another alternative is to raise grants from organizations like the National Science Foundation or the Small Business Innovation Research program. SBA loans can also be a good option for financing for many small businesses and startups.
Bottom Line on SAFE vs Convertible Note
The bottom line is that SAFE Notes and Convertible Notes are both common methods of funding early-stage startups, and have many similarities, but they also have key differences. It’s important to understand the pros and cons of each before deciding which is right for your company.
And speak to an experienced professional before making a final decision, so you can choose the best way to finance your startup!
Are you pitching venture capitalists? Read more about How to Create a Startup Pitch and How to Create a Venture Capital Pitch Deck.
