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Simple Agreement for Future Equity (SAFE) vs convertible notes

Understanding the funding options available to your business, especially during its first few years, can be critical to its continued success. This need for expert advice is why we created legal services for start-ups. In this article we compare SAFE and convertible notes, looking at the pros and cons of each.

Trends in seed funding – SAFEs and convertible notes and when you would use them

Seed funding is a term used to describe the investment needed by start-up companies. This is different from the initial ‘bootstrap’ funding provided by the founders, their family and friends, which is the very basic amount needed to develop and launch an idea.

Once a start-up has begun to trade, or at least has developed its business plan sufficiently to demonstrate a real possibility of commercial activity, the founders’ minds typically think about how to fund the next steps. The funding for this next period in a company’s growth most likely comes from seed or angel investors, as opposed to venture capital firms (VCs) who typically invest in more developed companies.

When VCs invest, they usually require preferential terms when it comes to the amount they’ll get if the company is sold or liquidates its assets, and this comes in the form of preferred shares. They often also ask for a say in company decision making so that they can retain some control over the company as a means to protect their investment.

A round of VC funding can be a time-consuming and expensive process for a start-up.  Typically, after a period of due diligence you need to amend the constitutional documents of the company (its Articles of Association) and enter into a share purchase agreement and shareholders' agreement with your new investors, all of which can eat up precious time (and resources).

If a VC involvement is substantial, then the time and money needed to draft and negotiate these documents is clearly worthwhile. When the investment is small, not so much. What founders and seed funders need most of all is simplicity, and this can be achieved by deferring complex issues like valuation until later funding rounds when VCs get involved.

This simplicity can be achieved by raising funding using Simple Agreements for Future Equity (SAFEs) and convertible notes, under which seed funders won’t get shares in the company until some point in the future, thus avoiding the need to establish firm valuations of the company or spend valuable cash on complex negotiations with VCs. This enables founders to raise money quickly. From an investor’s perspective, entering into a SAFE or getting a convertible note enables them to place their funds until Series A financing occurs, at which point they will have a better picture of how the company is performing.

In short, convertible notes are loan agreements that bear interest and convert into equity at a certain point in the future, and SAFEs are contracts that give investors the right to purchase shares up to the amount of their investment when a further funding round occurs.

Understanding SAFEs

Unlike convertible notes, SAFEs are not loans, so they don’t attract interest or have a maturity date by which they are expected to be repaid.  They enable investors to convert their funding into shares at a point in the future, based on the valuation of the company at that point (usually the next funding round, often series A). They can remain in place indefinitely, and investors don’t have any leverage over the way the company is run in the meantime.

SAFEs have the following characteristics:

  • The company is not required to repay them, so the founders don’t have the threat of insolvency hanging over them should they not have the cash if called
  • They don’t have an end-date, so the founders can be relaxed about when they look for the next funding round (that would normally trigger the SAFE to vest)
  • They are simple contracts so don’t take long to negotiate
  • They may allow the holder the right to purchase at a capped price (via a valuation cap) or at a discount so that the investor has an advantage over the price paid in a future funding round

Understanding convertible notes

While convertible notes are strictly loans, start-ups aren’t expected to repay them. Rather, the loan amount plus interest is intended to be converted into equity at a certain point in time (such as the next funding round), and on certain terms and conditions that are agreed up-front.

The company receives cash from the funder in return for a promise to repay that amount plus interest at the maturity date. Once the trigger date happens, the convertible note is turned into a notional amount of principal and interest that’s used by the investor to buy shares in the company.

Because seed investment is relatively risky, convertible notes tend to be structured so that investors can acquire shares at a lower price than the VC funders would achieve in future rounds. This is achieved by incorporating in the agreement either a (1) discount, (2) a valuation cap, or (3) a combination of the two.

A discount will give the holder of a convertible note a discount off the price paid for the company’s shares by future VC investors. The price per share that a holder of a convertible note will pay is calculated by reference to the principal of the note, plus accrued interest divided by the discounted price per share, in effect giving the holder of the note a larger number of shares than it would otherwise receive.

This may not be so advantageous if the company’s valuation is very high and in relation to the price offered to future VC funders, so often an investor will insist on a valuation cap. 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. A convertible note cap has the effect of fixing the value of the investor’s shares. If the valuation is less than the cap amount, the price paid per share will be the same as that agreed at the funding round. If the valuation is higher, the investor price per share will be calculated with reference to the cap, giving the investor a reward for their early investment in the company.

Difference between SAFEs & Convertible notes – pros and cons

Because SAFEs are not loans, the company does not have indebtedness on its balance sheets, so the threat of insolvency is reduced (when the maturity date of a convertible note is reached the company has an obligation to convert to shares or repay the loan).

SAFEs tend to be simpler to agree and negotiate than convertible notes, because they don’t involve maturity dates and interest rate terms. Because they can continue indefinitely, it’s not necessary to define when a conversion to shares will be triggered.

Both SAFEs and convertible notes allow founders to defer questions of valuation until some point in the future when the company has some trading history upon which to base a valuation.

In terms of downsides of both SAFEs and convertible notes, both generally use a combination of discounts and caps that give investors a better deal in terms of the price they pay for shares when the option to purchase is exercised than future VC investors. 

A side effect of this, and convertible notes and SAFEs in general, is that they can 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 the company’s ability to raise money in future rounds, potentially forcing founders to agree a ‘down round’ where shares are offered at a lower price than previous rounds.

Converting to equity – pro forma to agree calculation methods

Because of the multiplier effect of SAFEs and notes, it’s important to understand the concept of pre- and post-money valuations.

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 thus 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 convertible notes is to get your lawyers to draw up a pro forma capitalisation table upfront. This table should clearly show the impact those notes (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.

Unintended outcomes of using SAFEs or Convertible notes

Anti-dilution protection

Because SAFEs and notes don’t give their holders the right to a specific percentage of shares in the company until they are converted, in theory they will be as protected against anti-dilution as incoming investors in the funding round that triggers their conversion.

However, as we’ve seen, SAFEs and convertible notes are often issued with a valuation cap – the maximum valuation of the company to be used when converting the amount of the SAFE/note into the company’s shares. The net effect of this is that these early-stage investors get a better price per share than investors in later rounds, and thus an in-built protection against dilution. Furthermore, some notes and SAFEs are issued on a ‘most favoured nation’ basis that will allow them more favourable terms than future investors, if more SAFEs or convertible notes are issued.

Liquidation preferences

Another side effect of valuation caps is to allow these early SAFE/note holders greater protection in a liquidation scenario (liquidation or sale).

As we’ve seen, in a typical VC funding round, companies issue investors with preferred shares. These preference shareholders will get their money out of the company before holders of ordinary shares (the founders).

Because the effect of a valuation cap for SAFE and note holders is that they pay a lower price per preferred share when their SAFE/note is converted to equity, this has the net effect of providing them with a very generous liquidation preference  ­– more cash to these early-stage investors, and much less to the founders/new VCs. 

All of this might not matter so much if SAFEs or notes have relatively short lifespans and are used as an interim measure to raise cash. Since the company will progress quite quickly to an institutional funding round, this will trigger conversion of the SAFEs/notes, but since the company’s value probably won’t have changed much, the anti-dilution/liquidation preference effect (if any) will be small.

However, if the SAFEs/notes remain in place for a number of years and the company grows substantially in value over that time, the benefit to SAFE/note holders can be substantial, as in return for their cash they receive a higher number of shares than incoming investors/founders, and more preferred shares and hence a much higher liquidation preference for their buck. 

The net effect of this is to reduce future VCs appetite to invest since they will get a worse deal than SAFE/noteholders, thus negatively impacting the company’s financial position over time.  In addition, company founders are likely to see their ownership of the company diminish as the impact of SAFEs/notes becomes clear when a fresh funding round approaches.

What next?

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