There is the time in the life of every company to turn idea to product, create a prototype, move into the revenue producing stage, expand the product offering or generally make the company viable and it will need outside financing to get there. This first stage of funding is known as the seed round. At this stage, most companies don’t have paying customers, market traction, profits, or even revenue, making it difficult (if not impossible) to come up with a valuation of the company that properly reflects the company’s potential.
Here is where SAFEs and convertible notes come to the rescue. The big benefit of both is that they give startups a way to raise money without going through the valuation process and giving up a portion of the company at an early stage and low valuation.
SAFE stands for “simple agreement for future equity.” SAFEs have been around since 2013 and I have seen them become more and more popular in seed stage capital raises. SAFEs are truly simple, with minimal legal terms. In a SAFE, investors get the right to buy equity in the company after a triggering event, which is typically defined as the next funding round or a corporate transaction (i.e. the sale of the company).
A standard SAFE includes a valuation cap and/or discount that rewards SAFE investors for taking the risk of financing at an early stage. Investors also get priority in liquidation. So far SAFEs sound pretty similar to convertible notes—but here is where the important differences start.
As SAFEs don’t have maturity dates, they remain outstanding until the next round of financing, whether it takes months or years, or never occurs. There is typically no other conversion feature (other than the outright sale of the company), so investors have to rely on a follow-up capital raise to obtain equity. Also, there is no interest that accrues in a typical SAFE.
Convertible notes have been around for ages and are the traditional seed stage funding tool. A convertible note is a loan that carries interest and eventually converts into preferred stock after defined triggering events.
Conversion events typically include:
- The startup raises a predetermined amount of money in an equity round in the future.
- Another corporate transaction takes place, such as the sale of the company or an IPO.
They often also convert at the option of the investors at maturity.
Convertible notes have a maturity date which typically occurs between 12 and 24 months after issue. Like SAFEs, convertible notes include a valuation cap and/or a discount rate which means note holders are rewarded with converting at a lower price when the next equity financing occurs.
Pros and Cons of SAFEs vs. Convertible Notes
SAFEs and convertible notes are both useful seed funding instruments that allow fundraising without a valuation and avoid giving up equity when presumably the value of the company is at its lowest/hard to determine. However, there are pros and cons to each every start-up should keep in mind.
From a company’s perspective, there are significant pros to SAFEs: There is no maturity date which avoids a renegotiation of terms at the end of the term. Moreover, SAFEs don’t carry interest. They are also much simpler to set up and understand which cuts down on time and legal fees.
On the flip-side, the big advantages of SAFEs for companies makes them less attractive for investors. Although I have seen them used more and more often, some investors still shy away from them as they do not have some of the protective features of convertible notes.
Convertible notes have been around for ages and are commonly understood by investors, so it may be easier to attract investors. They also offer a few features that are more protective of investors’ interests.
For companies, however, the maturity date often creates the uncomfortable situation of having to renegotiate the terms of the notes at the end of the term if they don’t have the cash to just repay them.
The downside of convertible notes for all involved is often that they may take longer to negotiate due to their complexity and that they require more legal work/costs to set up.
In my book, if you have the choice, and you have potential investors lined up that are amenable to signing a SAFE, it is the preferred instrument for the seed round. However, both SAFEs and convertible notes are viable options. The most important feature they have in common is the avoidance of a valuation and the giving up of equity where presumably the value of the company is at its lowest.
However, one more piece of advice whether you are using SAFEs or notes: both may have unintended –disproportionate– consequences for your cap table especially if you are using a valuation cap. So, go ahead and run a few scenarios before issuing either to make sure you understand the dilutive impact of cap/discount. Also, you should talk with your tax advisor since the treatment of SAFEs from a tax perspective may still be uncertain, and never forget compliance with the securities laws.