July 23, 2020
As a budding startup you’re probably looking into funding options and seeing what all is available to you. If you are in the very early phases and just looking for initial investors, you should know your options are really limited. Banks and other traditional lenders and angel investors won’t even consider you because at this stage you’re pretty high risk for them.
You’re going to have to get creative with raising those crucial pre-seed dollars to keep your project going. Trust us, you’re not the first or last to have this problem. It’s always a chicken and egg problem with new businesses: you need money to make money. You need to grow, hire new employees, and likely invest in some equipment to get you going.
In exploring your options, you’ve probably come across SAFE notes and convertible notes in the startup world. SAFEs are really popular for start-up fundraising, but convertible notes have been around much longer. Both of these have grown in popularity recently, since they allow young startups to raise funding without the difficulties associated with valuation.
You’re definitely taking the right steps here in exploring your options and learning about what’s what before making a decision for your unique situation. However, you’ll want to consult with your financial professional before you make your final decision.
Since you’re likely new to this world, let’s get these terms defined.
<h3>What is a SAFE Note?</h3>
No, it’s not like a super secure cashier’s check (like I thought when I first heard the term), it’s actually an acronym:
Simple
Agreement for
Future
Equity
These were the brainchild of Y Combinator in 2013, the very same company who started the accelerator program you’ve heard so much about in the past decade. They came up with SAFE notes as a new alternative to simplify seed investment. It’s in the super short-term of a 5-7 page document you sign with your investors. Basically, it’s an agreement that establishes how the equity round will be treated when the next round of funding is attained. In most cases, we’re talking about a Series A investment.
SAFEs are the new version of convertible notes that are especially popular among Silicon Valley startups. Keep in mind, just because they’re new and different doesn’t mean they are necessarily better.
They’re also evolving over time. There are now four various different versions of the new SAFE notes for note holders that allow a bit more control than just using the cookie-cutter agreements of days past. These new versions include combinations of valuation caps vs. no valuation cap, discount vs, no discount, and “most favored nation” or MFN terms (the idea being that, in specified circumstances, the first party will be entitled to at least as favorable terms as a second party). There is also an optional pro rata side letter that can be included with the agreements. The new SAFE notes are not quite as “simple” as the old ones were.
<h3>What is a Convertible Note?</h3>
Convertible notes are initial equity investments that will eventually convert into equity. These are also sometimes known as “convertible debts” and they do accrue interest for the investor over time. Basically, the investor gives you, the startup founder, money now in exchange for equity at a later date with a discount, it is truly a simple agreement for future equity.
This later date is predetermined when the convertible note is purchased and is usually set with a triggering event, oftentimes a new round of funding or an acquisition. There is also a maturity date should the triggering event never happen. This means the note must be repaid or converted even if the company is underperforming.
<h3>What are Some Similarities?</h3>
We know there is a lot of overlap between convertible notes and SAFE notes, so we’re going to summarize those here. Later, we’ll go into what sets them apart to help you decide which one may work better in your business.
Caps, Discounts and Equity Dilution
A Cap amount is the maximum amount an investor will eventually have to pay for preferred shares once the notes convert, not the minimum amount. It is possible to negotiate an uncapped note, but really difficult. A low cap will allow investors to buy up more of your common stock or preferred stock with their initial investment.
Discounts—well we all know what discounts are—also will enable investors to convert to owning more of your stock once applied. As a founder, you’ll want to keep these percentages as low as you can. If you have a cap and a discount, the investor will go with whichever one gives them the better price.
The more stock of your company the investors receive once their notes convert, the lower your ownership is in your own company. This is called equity dilution and can really come back to bite you when you’re looking for more funding from other sources. Once big pieces of your pie have been eaten up by early investors and founders, there won’t be too much left for Series-B investors to be interested in.
Early Exit Clauses
Generally, both SAFE and convertible notes will have similar terms in the event your company is acquired prior to conversion. If you have a sale of the company, typically the terms for both end up being a cash payout or post-money equity on an “as-converted basis.”
<h3>What are the Differences?</h3>
At first glance, these might seem like they’re basically the same thing: a piece of paper saying I owe you stock later for money now. The differences are in the details, as with most things legal and financial.
Repayment
A SAFE is there to simplify a convertible note, thereby making it easier and cheaper to issue them. A SAFE note, unlike a convertible note, is a simple written agreement between an early stage startup founder or co-founder and investor which provides for the convertible debt into priced equity. A convertible note is debt, which means it will accrue interest rates like a loan, and needs to be repaid should the note reach its maturity date.
Should your company not achieve venture capital by this date, you will need to pay up regardless at the end of the financing round. Convertible security loans have been the proverbial straw breaking the back of many companies already going through financial difficulty. If you take one out, keep in mind how you will repay it should your next round of funding not come, or arrive too late.
Conversion Triggers
Convertible notes are a bit more flexible when it comes to conversion triggers. The trigger can occur in the same or next round of funding, or can be tied to a certain amount or event. What this allows is a level of change of control about when a conversion occurs, so it does not trigger for an investment of any size.
The latter is true in the case of SAFEs. Even if your next round of investment is relatively small, the conversion is triggered upon the occurrence of the event, and the investor now owns stock in your company. Having convertible notes would allow you to raise smaller amounts of money to bridge the period between seed and Series A. This could extend your runway a bit longer. Even a couple extra months for an early-phase startup can mean the world with regard to fine tuning or preparing for a launch.
Interest
While both SAFEs and convertible notes are promises of equity at a later date and the issuers will both end up with part ownership of the company, convertible notes weigh heavier in this regard. Due to the interest being accrued, all other terms and initial investment being the same between a SAFE and convertible note, once the conversion happens, the investor with the convertible will generally have more purchasing power due to the interest accrued.
Convertible notes are debt, whereas SAFE notes are warrants.
Simplicity
While conversion notes used to be known and loved for their lower level of paperwork and overall efficiency compared to other funding options, the new guys in town take the cake. SAFEs are really simple—after all, it’s in the name! The documents are really short and the provisions are presented with little negotiation needed.
This simplicity is a bit of a double-edged sword, however. Because they are so “out of the box ready” there isn’t much that can be customized in the terms. Convertible notes, on the other hand, do lend themselves to being a bit more comprehensive, with more robust terms and conditions. This also enables you to negotiate with the investor and maybe get better terms for yourself.
<h3>So Which is Better for Me?</h3>
The answer to this question is really going to depend on your own particular business situation, along with your personal preference. While doing your own research is great and clearly as a young start-up founder looking into initial funding, money is really tight, you should really avoid making big financial decisions without consulting a financial and legal expert first. This is the future of your budding company we’re talking about here, so you want to make sure it’s handled properly.
When you do make your decision, especially if you opt for the more complex convertible notes, it’s really important not to write out the notes and terms yourself. Although they are simple when compared to conventional funding methods like loans, there is still tricky math and clauses you need to include to protect yourself and the value of your company in the future. Make sure you’re working with a lawyer from a credible law firm throughout this process to ensure it’s all taken care of properly.
