In this article, we cover how you can determine which type of investment will meet your startup’s needs and help you gain access to funding. It is helpful to first understand why equity financings are typically not used when a startup is first starting out.
Suggested reading: Priced and Unpriced Financing Rounds: What are the Differences?
Why can’t startups just issue equity to investors instead of using convertible notes or SAFEs?
Convertible financing instruments such as convertible notes and SAFEs exist largely for tax reasons, or, more specifically, to minimize the risk of startups and startup founders being audited by the IRS.
When a company first starts out, the company is worth almost nothing and the founders are able to buy their shares at time of incorporation for a small amount of cash at a price equal to the par value (minimum price, as specified in the company’s articles of incorporation).
If that startup were to turn around 3 months later issue and preferred shares to investors in a priced round at $2.00 per share, this would look fishy to tax officials and potentially draw scrutiny from IRS auditors.
To avoid issuing equity at a steep markup so soon after a company incorporated, startup lawyers invented convertible notes, which are effectively a loan or debt instrument that must either be paid back with cash before the maturity date or the note will convert into shares when the company raises a priced financing round.
The Standard Agreement for Future Equity, or SAFE, was drafted by Y Combinator in conjunction with Orrick, a top startup law firm in 2013. The SAFE is a simplified version of the convertible note and removes the loan and maturity date altogether.
To put it in other terms, a convertible note is debt, while a SAFE is a convertible security. The SAFE is much simpler and shorter than convertible notes.
SAFE Offers Simplicity and Standardization
Convertible notes can be intricate and lengthy. On the flip side, SAFEs are 5 pages long and were created solely for the purpose of streamlining the seed investment process.
You will typically have to engage a lawyer to draft a convertible note agreement or review the note sent to you by a prospective investor. By contrast, with a SAFE, most founders find they do not have to bother with talking to a lawyer. The agreement is straightforward and it is typically *never modified*. One of the clauses in the contract is that it has not been modified from the terms published on the YCombinator website.
Because of the reduced friction to understanding and agreeing to the investment terms, founders can usually close financing deals faster when using SAFEs.
Capbase makes it easy to raise funds for your startup using the SAFE or a standardized convertible note. Our software automatically updates your cap table as you sign investment agreements.
Conversion into Equity: Differences between SAFEs and Convertible Notes
A SAFE and convertible note both allow for conversion into equity. The key difference is that SAFEs only allow for conversion into the next round of preferred stock issued by a company in the next priced financing round. On the other hand, convertible notes allow for conversion into the current round of shares or a future financing event where a new series of preferred stock is issued.
In addition, convertible notes typically have specific thresholds for conversion triggers, such as when a “qualifying transaction takes place”, such as a minimum amount of funds raised by the company, or when both the company and the investor agree on the conversion. The SAFE converts when you raise any amount of equity financing in a priced round. This is neat and simple, but it is sometimes less flexible for founders.
Valuation Cap and Dilution Math using SAFEs and Convertible Notes
Most startups that are raising their first funds from investors using a convertible note or a SAFE usually sign financing agreements that include a valuation cap. If your company has solid traction numbers and you are a strong negotiator, you may be able to negotiate a SAFE or convertible note that is uncapped, meaning it has no valuation cap attached. When startups raise bridge financing in between equity financing rounds, convertible notes are often used without a cap, but with a discount of 10% or 20% (or even more) on the priced financing round which will happen soon thereafter.
As a founder raising funds using SAFEs or convertible notes, it is important to understand what is happening to your cap table and how much your ownership stake as a founder will be diluted. SAFEs are convenient to use, but by avoiding equity financing and issuing preferred shares, founders sometimes end up giving away more of the company than they originally anticipated. Then, when they go to raise their first priced financing round, the dilution numbers can be quite shocking. When you send a SAFE to an investor on Capbase, our software models the dilution so you always understand how much of your company you are selling to a specific investor.
Different Outcomes When Taking an Early Exit
If you are looking to sell your company early, convertible notes and SAFEs have similar payout mechanisms when a change of control occurs (like an acquisition or an IPO) before conversion into preferred shares in the next priced round.
When a company is acquired, SAFEs give the investor the choice of a 1x payout or conversion into equity at the valuation cap.
On the other hand, the payout provisions vary in convertible debt agreements, and typically 2x payout provisions are the norm. These types of payout provision changes could be written into SAFE agreements through the use of a side letter.
Low vs. Zero Interest Rate
SAFEs are not a debt instrument and instead are defined as a warrant. They do not have a maturity rate or an interest rate. By contrast, convertible notes have an interest range that usually ranges between 2% and 8% with most falling around 5%.
Many founders prefer SAFEs because the ownership stake the investor is buying will not vary based on how long the SAFE is held, like occurs with convertible notes that bear an interest rate.
Maturity Date: What Happens When Convertible Notes Mature Before A Priced Round
Because SAFEs are not a debt instrument, they do not have a maturity date. Convertible notes do. This can cause some issues for founders when the maturity date passes prior to raising a priced round.
When a convertible note “matures”, the founders have three choices:
1. Pay back the principal plus interest (if the company has enough money to do that)
2. Convert the debt into equity
3. Renegotiate the maturity date with the investor(s)
Paying back the principal can be difficult to do for a company that is not profitable and does not have the money in the bank. This could even trigger a bankruptcy.
Many founders strongly prefer using SAFEs over convertible notes for the simple fact that the SAFEs do not have to be paid back since they are not a loan.
Structure and Flexibility
Generally speaking, it is easier to issue SAFEs to different investors at different valuation caps or different investment terms. This sort of “high-resolution” financing allows founders to easily execute a rolling raise, where they test the market by increasing the proposed valuation cap as there is increased inbound interest from investors.
Executing this fundraising strategy using convertible notes can be quite cumbersome from the legal perspective, not to mention that having different maturity dates with different valuation caps and different interest rates is a nightmare from a cap table tracking perspective.
SAFEs are typically “stand-alone” and can be easily issued at different times, for different amounts and with different terms attached.
By contrast, convertible notes are typically structured with a single legal agreement governing the convertible note financing, called a “Note Purchase Agreement” or NPA. This contract contains the meat of the substantive terms in the financing round and then short “Promissory Notes” will be issued to each individual investor to document the date and amount of each investor’s investment.
Investor Familiarity / Tolerance
If an investor is willing to use a SAFE to fund your company, the investor will almost certainly be comfortable with using a convertible note as well. The opposite is not true, especially outside Silicon Valley. If an investor is willing to invest using a convertible note, there is no guarantee that that same investor is familiar with using SAFEs.
Raj Sandhu, a partner at Great Oaks VC, who has been investing in Silicon Valley startups (including Capbase) for over 25 years, says of SAFES vs Convertible notes:
Convertible notes by their nature had restrictive covenants, time based terms, interest rates, priority in liquidation etc, and could tie up collateral and assets. Founders would have to go back to investors to get notes extended, or amended to increase size. So in that regard they were more ‘investor friendly.’ They also required founders to go back to investors for waivers in case they needed to extend term, amount, etc. or if they were getting bank debt.
By contrast, SAFEs are more 'founder friendly'. Because they aren’t debt instruments, founders did not have to deal with the above. Also, by virtue of YC making them open source, it saves hiring counsel on both sides to haggle terms.
As time has passed, more and more investors outside of Silicon Valley are becoming comfortable and familiar with SAFEs in startup financing as their usage has grown since the SAFE was first introduced in 2013. However, a startup raising funds at seed or pre-seed may still encounter a potential material investor who will only invest using a convertible note or equity financing, but not SAFEs.
- Convertible notes are loans or debt instruments
- SAFEs are not debt or loans and so they have no maturity date or interest rate
- Convertible notes have a maturity date and interest rate
- Both SAFEs and convertible notes have valuation caps and discounts
- The SAFE was introduced by YCombinator and Orrick in 2013 to streamline venture financing for early stage startups
- Many founders prefer SAFEs because they are simpler and do not typically require the assistance of a lawyer to draft or review
- When raising funds from investors, it is important to keep your cap table updated. Capbase automatically updates your cap table and document room when you issue SAFEs or convertible notes to investors as part of your fundraising process.