Introduction
You may have heard of SAFEs and Convertible Notes if you’re an entrepreneur trying to raise capital for your Startup. These two forms of financing enable you to get money from investors without giving equity or valuing your business up front. The investors are given the option to convert their capital into equity in a subsequent round of funding, typically at a discounted cost or a capped valuation.
Straightforward, right?
Umm, not quite.
Before entering into any agreements, you must have a thorough understanding of all the subtleties and trade-offs associated with employing these instruments.
In this Review, we go through the key characteristics, distinctions, benefits, and drawbacks of SAFEs and convertible notes.
By the end, you should be better situated to determine if SAFEs or convertible notes are appropriate for your business.
Convertible Notes and SAFEs: Definitions
1. Convertible note
It is a type of debt that can be converted into equity in the future. Startups that aren’t yet prepared for a conventional equity fundraising round frequently employ it. A maturity date for convertible notes designates when the investor must be paid back. The investor will be compensated with stock in the business if the company has not raised a priced equity round before the maturity date.
Some of the key terms for understanding convertible notes are:
Interest Rate: The amount of interest that accrues on the loan and is paid in the form of equity when the note converts.
Discount Rate: The percentage by which the investor can buy shares at a lower price than the market value when the note converts.
Valuation Cap: The maximum valuation at which the investor can convert their note, regardless of the market value.
Maturity Date: The deadline by which the company needs to repay the loan or extend the agreement.
A SAFE (Simple Agreement for Future Equity) is a simplified convertible note with fewer provisions than a regular convertible note. Y Combinator created it in 2013 to remove the complexities associated with convertible notes while keeping the finest elements. SAFEs have no maturity date and convert to stock at a specified valuation when a firm raises a priced equity round.
Some of the key terms for understanding SAFEs are:
Valuation Cap: The same as for convertible notes, but it applies to all SAFEs regardless of when they were issued.
Discount Rate: The same as for convertible notes, but it only applies if the company’s valuation is at or below the valuation cap.
Pro Rata Rights: The right of the investor to maintain their ownership percentage in future rounds by buying more shares.
To view it in simple terms, both instruments are quite similar except for the fact that convertible notes can be seen as debts because there are interest and maturity clauses attached to them. But SAFEs are not essentially debts because there is no predetermined interest rate or maturity date.
However, if the ‘not a debt’ feature of SAFE is tipping the balance in its favor, then, hold on! As is true with everything, SAFE also has its own set of benefits and limitations and so do Convertible Notes. You need to have a thorough understanding of these before making any decision. We have created a balance sheet of benefits and limitations for both methods.
SAFE: Benefits and Limitation
| SAFE | Benefits | Limitation |
| No Risk of Debt A SAFE note is not considered a debt instrument. As a result, the company utilizing a SAFE note does not face the concern of accumulating debt. | Uncertain Equity Since SAFEs can only be converted into equity if the startup is able to raise the next round of funding, there is a risk that the investor might not get any equity at all. Hence, some investors may not show interest in SAFEs. | |
| No Maturity Date SAFE notes don’t have a specific maturity date. These notes can be held by investors until the company successfully raises its next round of funding. | No Revenue from Interest Investors don’t have the advantage of generating revenue from interest, which can be another reason they may not be very willing to go with SAFEs. | |
| No Added Interest SAFEs are free of interest, which is hugely convenient for Startups. | No Dividends for Investors In general, investors will not earn dividends from SAFEs since equity is the only reward they can have. | |
| Simple and Easy Processing SAFE notes are less complex and easy to understand. Since there is no maturity date and interest rate, the only things to negotiate are the discount rate and valuation cap. This makes the process less complex and time-taking. | Limited Access In most of the countries only incorporated (legally recognized) businesses can issue SAFEs. |
Convertible Notes: Benefits and Limitations
| Convertible Notes | Benefits | Limitations |
| Safe For Investors Convertible notes provide investors with a relatively safe option to acquire equity in a corporation during the seed funding stage. If the corporation fails to progress, the investment is treated as debt, and investors are repaid through asset liquidation. | Risk of Liquidation Convertible notes carry significant investment risks. If a firm fails to secure a favorable valuation from another investor, it must repay the notes in cash, potentially leading to asset liquidation. This situation is detrimental to both founders and investors, with the risk of bankruptcy for the company and potential loss of invested funds for investors. | |
| Less Initial Paperwork and Expense Convertible notes offer an informal and streamlined process without the need for valuation agreements, resulting in reduced paperwork and lower transaction costs. This is particularly beneficial for startups in the pre-seed funding stage. | Chances of Manipulation The value of convertible notes is typically determined by third-party investors in later stages, not by the initial investors or founders. This valuation influences the value of the notes, and therefore both initial and later stage investors may attempt to manipulate it for their advantage. | |
| Delayed Valuation At an early stage, both investors and founders are hesitant to value the firm due to the lack of industry traction. Investors fear lower valuations, while founders may be worried about overevaluation. Convertible notes allow them to delay the valuation decision to a later stage when both parties have greater insights about the value of the company | Chances of Conflict Selling convertible notes to multiple investors can lead to conflicting interests and complications if the deal is not properly structured. It is crucial for a company to avoid such complications to prevent negative impacts on the interests of all stakeholders involved. | |
| Safety of Valuation Cap Convertible notes often include a valuation cap clause to prevent excessive equity transfer at a low price. This cap sets a limit on the maximum equity that investors can receive upon conversion. The presence of a valuation cap provides founders with a sense of comfort when utilizing these notes. |
Risk Assessment: SAFE vs Convertible Notes
So, which one is riskier for founders? Well, as discussed above each option has its own risks and it’s important for founders to understand these risks before making a decision.
Convertible notes are debt instruments, which means that they must be repaid if they don’t convert into equity. This can be a major financial burden for startups that are struggling to raise additional funding. However, convertible notes can also protect founders from excessive dilution by setting a valuation cap.
SAFE agreements, on the other hand, are equity-based instruments. This means that they don’t have to be repaid, but they also don’t provide any protection from dilution. In other words, there is uncertainty regarding the equity terms and potential dilution for founders until a priced round occurs.
So, the safety depends on the specific circumstances of the startup. If a startup is confident that it will be able to raise additional funding in the near future, then a convertible note may be a good option. However, if a startup is facing financial uncertainty, then a SAFE agreement may be a safer bet. Overall, the safety for a startup in both scenarios primarily depends on the terms negotiated with the investor, startup’s ability to secure future financing, success of the business model and overall market condition. Ultimately, the best way to mitigate the risks of either option is to carefully evaluate the terms and implications of both convertible notes and SAFE agreements by seeking help of professionals and legal experts before making a decision.
Conclusion
Both convertible notes and SAFEs provide distinct benefits and risks to companies seeking investment. The decision between the two is influenced by a startup’s unique requirements, financial status, and investor preferences. Before making a selection, founders must completely grasp the qualities, benefits, and limits of both solutions and seek professional counsel.
Let us know your doubts and views in the comments below.
