SAFE vs. Convertible Notes
When you are preparing to raise funds for your startup business, you will need to make a choice on how to move forward in searching for seed capital. Outside of straight equity there are generally two options, SAFE (simple agreement for future equity) or Convertible Notes. Every entrepreneur should fully understand their options to make sure they fit in with the long term strategy and future growth and fundraising plans.
A senior convertible note is a debt security that contains an option in which the note may be converted into a predefined amount of the issuer’s shares. A senior convertible note has priority over all other debt securities issued by the same organization. Just like any other debt investment, senior convertible notes offer investors the ability to earn interest. Rather than cash payments, however, the interest payments typically will accrue and the amount the company owes the investor will increase over time.
A convertible subordinate note is a short-term debt security issued by a company that can be exchanged for its common stock at the discretion of the bondholder. It is a short-term convertible bond, which ranks below other, more senior loans (it is junior to other debt).
Simple Agreement for Future Equity (SAFE)
At its core, a SAFE is a warrant to purchase stock in a future priced round. The concept was created by the Silicon Valley accelerator Y Combinator. You can explore forms and SAFE variations on their site.
Similarities Between SAFE and Convertible Note Instruments.
Both act as a viable way to help startups through the big hurdle in growing or scaling to reach the milestone of a Series A round. Also, both options carry a discount on the next round (or current round for convertible notes), so neither presents a clear advantage. With this in mind, looking at the differences will help an entrepreneur consider the pros and cons in determining their preference for seed investment terms.
6 Seed Investment Variables To Consider When Comparing a SAFE with Convertible Notes
1. Equity Conversion Differences
Both SAFE and convertible notes allow for conversion into equity. However, a SAFE only allows for a conversion into the next round of financing. Convertible notes can allow for the conversion into the current round of stock or a future financing event. Convertible notes typically trigger when a “qualifying transaction takes place” (as dictated in the agreement) or when both parties agree on the conversion.
Raising common stock doesn’t trigger a conversion for a SAFE investor, so if an entrepreneur has a need for cash at the wrong time they could do a private “family and friends round” and not hit the conversion trigger. A SAFE can convert when you raise any amount of equity investment. This is nice for simplicity, but it doesn’t give the founders control. This is why the convertible note might look to be the best choice for seed investment in the equity category.
2. SAFE, Simple, Streamlined and Limited
Convertible notes are often intricate and complicated by the time the term sheet becomes a fully negotiated contract. Whereas a SAFE is a simple, short document created to streamline the seed investment process. Unlike convertible notes and for simplicity’s sake, they do not offer an interest rate and they do not have a maturity date.
3. Valuation Cap Considerations
Valuation caps, also known as conversion caps, for SAFE and Convertible Notes, place a limit on the value of the company so that the note converts at no more than the agreed-upon cap.
“Founders have a tendency to associate the valuation cap on a note with the future floor for an equity round; that they further assume that any note discount implies the minimum premium for the next equity round; and that many founders don’t do the basic dilution math associated with what happens to their personal ownership stakes when these notes actually convert into equity. By kicking the valuation can down the road, often multiple times, a hangover effect develops: Entrepreneurs who don’t do the capitalization table math end up owning less of their company’s equity than they thought they did,” TechCrunch.
Understand that should you forgo a valuation cap at the seed stage, you could be diluting your shares and your future investors’ shares when you go to raise your Series A. It’s important to get your capitalization table math correct with either choice.
4. Low to No Interest and Early Exits
A SAFE is Actually a warrant and that means they do not carry an interest rate. Convertible notes do carry an interest rate typically ranging from 2 to 8%, usually falling in the middle around 5%. Not having to make payments could give SAFE an advantage.
If you find yourself in need of an early exit (IPO or acquisition), convertible notes and SAFEs offer a similar payout mechanism should there be a change in control before a conversion occurs. The SAFE is typically written to give the investor the choice of a 1x (unless cash-out multiplier is specified they default to 1x) payout or conversion into equity at the cap amount to participate in the buyout.
There are typically 2x payout provisions in convertible debt agreements, which can still be written into SAFE agreements. Both options offer seed investment advantages that ultimately depend on your preferences.
5. Conversion Discounts, More For Less
The phrase, more bang for your buck, could be used to sum up what a conversion discount does and why an investor would want this included. In essence, the potential of buying more with less.
A conversion discount is a negotiated lower share price for when you convert your note to stock. When you have a convertible note, that debt will convert to equity in the next preferred round of financing.
For example, imagine an investor who is owed $10,000 for their convertible investment with a 20% conversion discount. The new equity round is set at a $2.00 price per share. The price per share is discounted by 20%, which calculates to $2.00 x (1 – 0.20) = $1.60. The principal amount is converted using the discounted price per share for a total of 6,250 shares ($10,000 / $1.60). Carta.com
6. Maturity Date Matters
SAFEs do not have a maturity date whereas convertible notes do, which can create problems when the maturity date comes to pass. At maturity there are two choices, payback the principle plus interest or convert the debt into equity. Simple enough, however if the company is not doing so well at the maturity date the investors may want their money back which could kill the company. A concern that might make the SAFE a better choice
Bonnie Brown is an experienced business executive, CPA and Cofounder of Passion Placement with extensive US and global expertise in accounting, finance, raising funds, in both private and public markets, SEC reporting, taxes and leadership.