Early investment or seed funding is crucial to founders who need cash upfront to grow their business though marketing, product development, making key hires and so on.
Investors may be interested in the business because of its high growth potential but might be hesitant to invest based on an early valuation. Flexible investment structures such as simple agreements for future equity (SAFEs) and convertible loan notes (CLNs) can bring investment into the start-up while delaying formal valuation until the next funding round.
If you’re thinking of entering into a SAFE or CLN, then you’ll need expert legal advice – that’s why we created legal services for start-ups. In this article, we examine and compare SAFEs and CLNs in more detail, looking at the key differences and the advantages and disadvantages of the two instruments.
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What is a SAFE?
SAFE notes were created in 2013 by an organisation in the US called Y Combinator, which provides seed funding and resources to start-up companies. They were created as an alternative to convertible notes in order to standardise and simplify the seed funding process.
A SAFE is a financing agreement between a company and an investor under which an investor injects cash into your company but doesn’t receive shares until a later date, usually when you complete a full funding round. The amount of shares received is based on the valuation of the company at that point and so equity is typically offered at a discount to reflect the fact that the SAFE investors have taken a bigger risk by putting their money in first, ahead of the other investors in the funding round.
SAFEs are a form of convertible security not debt, so they don’t attract interest or have a maturity date by which they are expected to be repaid. They can remain in place indefinitely and investors don’t have any leverage over the way the company is run in the meantime.
Because SAFEs are relatively easy to draft and negotiate and you don’t need to pay interest on them, they are a flexible way to raise funds. They are considered more founder-friendly than CLNs as they do not have to be repaid if the venture is unsuccessful.
What is a CLN?
A CLN is a loan agreement which accrues interest but rather than being repaid, the debt is intended to convert to shares upon an agreed event (such as a financing round). In a similar way to SAFEs, the amount of equity is calculated at the time of the funding round, and a discount and/or valuation cap is usually incorporated into the terms to reflect the greater risk of early investment.
This conversion to equity may not be so profitable if the company’s valuation is very high so often an investor will insist on a valuation cap. This is an upper limit on the valuation of the company at the time of conversion which translates into another discount for holders, if there is already an agreed discount rate on the shares.
For example, if the valuation cap is £1 million but the company is valued at £2 million, then investing £250,000 will mean the investor gains a 25% stake in the equity of the company rather than a 12.5% stake. This ensures that holders can hedge the amount they pay for their shares depending on the valuation of the company at the time of conversion.
Comparison of SAFEs vs CLNs
| SAFE | CLN | |
| Interest rate | no - interest is not charged on a SAFE | yes - interest accrues but the interest is usually ‘paid’ in shares when the note converts |
| Maturity date | no - no maturity date or expiration date, so you can be relaxed about when you look for the next funding round (that would normally trigger the SAFE to vest) | yes – usually 18-24 months - if the note is not converted to shares by the maturity date then either the loan has to be repaid in cash, an extension requested or an early conversion to shares may occur |
| Discount rate | usually but not always - there is an option to incorporate a discount rate if agreed | typically holders receive a pre-agreed discount when buying shares on conversion |
| Valuation cap | usually but not always - there is an option to incorporate a valuation cap if agreed | holders may also benefit from a valuation cap |
| Speed/simplicity | simple contracts with standard clauses so shouldn’t take as long to negotiate | number of terms and conditions which may require lengthy negotiation |
| Trigger events | next fundraising round | various events including reaching certain thresholds for fundraising or even on an agreed time for conversion |
| Repayment | no – not repayable | yes – repayable together with accrued interest if not converted to equity |
| Structure | more flexible – can be issued on a rolling basis with varying terms | usually an overarching legal agreement which contains all of the terms and then promissory notes issued to individual investors |
| Investor risk | more risk to investor – may have to wait a long time for conversion with no interest accruing or if the start-up is not successful, investors will lose their money | less risk to investor – the note is a debt which needs to be repaid or converted to shares by the maturity date |
| Investor Rights | Usually no voting rights until conversion | May have limited voting rights until conversion |
| Investor confidence | only introduced in 2013 so some investors not yet comfortable investing this way | more familiar traditional financing for investors |
Advantages and disadvantages of SAFEs
| Advantages | Disadvantages |
| No interest payable and reduced risk of insolvency as not a debt on the balance sheet | Investors may insist on a discount on the share price of the future funding round |
| No repayment obligation and no maturity so can stay in the background until the next funding round | Riskier for investors as no repayment obligation may put investors off at the early funding stage |
| Simple, cheap and quick to agree and negotiate – no maturity and interest rate terms or conversion trigger (they can continue indefinitely) | More time-consuming to negotiate as tend to be negotiated for each individual investor |
| Flexible - the individual negotiation of a SAFE note allows the founders to test the market and make adjustments to terms as they go | Relatively new funding method - investors may not be comfortable using them yet and founders may struggle to attract the number or type of investors needed |
| If correctly structured can be SEIS/EIS eligible | For SEIS/EIS investors, conversion into equity must take place within 6 months of investment |
| Retain control of the company during the crucial growth phase as can delay the issue of shares– investors typically have no voting rights or board representation until conversion | May lead to ‘dilution waterfalls’ or a ‘multiplier effect’, as large percentages of the company are effectively given away in advance of future funding rounds. This can negatively impact your ability to raise money in future rounds, potentially forcing you to agree a ‘down round’ where shares are offered at a lower price than previous rounds |
| Allow you to defer questions of valuation until some point in the future when the company has some trading history upon which to base a valuation - avoids any tax implications | Uncertainty of share ownership as valuation is not determined until a future funding round |
Advantages and disadvantages of CLNs
| Advantages | Disadvantages |
| Been around for a very long time, they are an established, reliable funding method so more likely to attract a wider pool of investors | Not available for SEIS/EIS investors |
| Less risky for investors as they are structured as a debt so may appeal to more investors giving you potential to raise a larger amount of funds | If a conversion event doesn’t happen by the agreed longstop date, the company is likely to be required to repay the principal and interest |
| Structured as a debt so no immediate dilution for existing shareholders | Debt on which interest accrues - potential of insolvency on default. Incurring debt via a loan can be stressful for founders and lead to cash flow issues |
| May require more negotiation upfront but easier to roll out to investors as the terms have already been negotiated | More costly and time-consuming upfront negotiation to agree maturity dates and interest rate terms |
| Retain control of the company during the crucial growth phase as can delay the issue of shares although note holders may have limited voting rights until conversion | May lead to ‘dilution waterfalls’ or a ‘multiplier effect’, as large percentages of the company are effectively given away in advance of future funding rounds. This can negatively impact your ability to raise money in future rounds, potentially forcing you to agree a ‘down round’ where shares are offered at a lower price than previous rounds |
| Allow you to defer questions of valuation until some point in the future when the company has some trading history upon which to base a valuation - avoids any tax implications | Uncertainty of share ownership as valuation is not determined until a future funding round |
Pre and post money valuations
Because of the multiplier effect of SAFEs and CLNs, it’s important to understand the concept of pre- and post-money valuations and how ownership percentages may be diluted in future funding rounds.
A pre-money valuation refers to the company’s value before a funding round. This tells investors how much a company is truly worth, regardless of finance received, and gives them an idea of the value of each share in that business.
A post-money valuation refers to the company’s value after a funding round, when investment has been received.
One way to ensure that both founders and investors truly understand the impact of issuing SAFEs and CLNs is to get your lawyers to draw up a pro forma capitalisation table or 'cap table' early on.
Cap tables
The cap table is a central tool to understand and demonstrate to investors current and projected share ownership which in turn will be used to calculate rights to decision making, dividends, board appointments, information rights and other core shareholder rights.
The cap table should clearly show the impact the SAFEs or CLNs (including any discounts or valuation caps) will have on the percentage share ownership between founders and investors after the conversion to equity has taken place – the post-money position.
Our corporate team have extensive experience in creating cap tables for start-ups and we can provide scenario planning for future funding rounds, showing how different funding options, such as SAFEs or CLNs, may impact your business and equity structure down the line.
An inaccurate cap table can not only destroy investor confidence in the management ability of the business but can also lead to inaccuracies in company registers and other legal documents. This is not only embarrassing but can also lead to delays in completing the funding round. If inaccuracies are not corrected at an early stage, it could also lead to costly and disruptive disputes between owners further down the line.
Other considerations when using SAFEs or CLNs
Anti-dilution protection
SAFEs and CLNs are often issued with a valuation cap meaning early-stage investors get a better price per share than investors in later rounds, and an in-built protection against dilution. It is crucial as a founder to calculate how much your ownership stake may be diluted in future financing rounds before agreeing on a valuation cap, which is where the cap table comes in.
Some convertible notes and SAFEs are also issued on a ‘most favoured nation’ basis that will allow investors to inherit any more favourable terms that are offered to subsequent investors.
Liquidation preferences
A consequence of valuation caps may be to allow SAFE or CLN holders greater protection in a liquidation scenario (liquidation or sale) as the holders would have an original issue price equal to the price per share that the subsequent investors paid, rather than an original issue price equal to the actual price per share paid as a result of the valuation cap.
This liquidation preference can be limited by adding in protections for founders and subsequent investors into the SAFE or CLN documentation and may include issuing a parallel series of preferred shares which reflect the actual price per share paid by the SAFE or CLN holders.
What’s the best route for me?
Both SAFEs and CLNs have pros and cons which we have explored above but deciding which one is best for you as a founder will depend very much on the nature and circumstances of your business and the type and quantity of investor you are seeking.
As a founder, you may prefer the SAFE option as they are not repayable and don’t accrue interest unlike CLNs. For very early-stage start-ups, a SAFE may also be preferable as it should be quick and simple to agree and is focused on future growth. CLNs may be preferable for businesses which need to raise a greater amount of funds and so need to attract a larger pool of investors, as CLNs offer greater investor protection.
Summary
In summary, both SAFEs and CLNs work in similar ways and are aimed at raising early-stage investment for start-ups. They are both structured to allow investors to acquire shares at a lower price than investors would achieve in future funding rounds and to convert this investment to equity at a later date when the valuation of the business is clearer. There are also key differences between SAFEs and CLNs and deciding which one is right for your business will depend on a number of factors.
At Harper James, we can give guidance on SAFEs and CLNs and assess the impact of these financing instruments on your business and equity structure. We can also assist with the legal framework and documentation to support your funding rounds so please get in touch with our corporate team if you have any questions or would like to discuss further.
