Early investors are crucial to start-up businesses and seed funding options such as SAFEs and convertible notes are ways to attract such investors by offering a higher return on the company’s shares further down the line.
Because seed investment is relatively risky, both SAFEs and convertible notes tend to be structured so that investors can acquire shares at a lower price than investors would achieve in future financing rounds. This is typically achieved by incorporating in the agreement either a discount, a valuation cap or a combination of the two.
If you’re thinking of entering into a SAFE or convertible note, 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 convertible notes in more detail.
- What is a SAFE?
- What is a convertible note?
- Comparison of SAFEs vs convertible notes
- Advantages and disadvantages of SAFEs and convertible notes
- Converting to equity – pro forma to agree calculation methods
- Other considerations when using SAFEs or convertible notes
What is a SAFE?
A simple agreement for future equity or SAFE is a financing agreement between the company and an investor which grants the investor the right to receive 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).
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 convertible notes as they do not have to be repaid if the venture is unsuccessful.
SAFE notes were created in 2013 by an organisation in the US called Y Combinator, which provides seed funding, mentorship, and resources to start-up companies. They were created as a simple alternative to convertible notes in order to standardise and simplify the seed funding process.
What is a convertible note?
A convertible note is a company loan which accrues interest but the debt (the loan amount plus interest) is intended to convert to shares upon an agreed event (such as a financing round) rather than being repaid.
The company receives cash from the investor in return for a promise to repay that amount plus interest at the maturity date. This may not be so advantageous if the company’s valuation is very high and in relation to the price offered to future investors, 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. 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 convertible notes
|Interest rate||no - interest is not charged on a SAFE||yes - interest accrues but the interest is ‘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||yes - 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||yes - holders will benefit from a valuation cap|
|Speed/simplicity||simple contracts with standard clauses so shouldn’t take 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 – 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 confidence||only introduced in 2013 so some investors not yet comfortable investing this way and more financial risk for investors||more familiar traditional financing for investors and less financial risk|
Advantages and disadvantages of SAFEs and convertible notes
- SAFEs don’t incur interest and don’t need to be repaid
- Because they’re not loans, with a SAFE you won’t have any debt on your balance sheet so the threat of insolvency is reduced
- SAFEs tend to be simpler and cheaper 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
- SAFEs don’t mature, so they can stay in the background until you’re ready for the next funding round
- For both SAFEs and convertible notes, you won’t immediately issue equity so will retain control of the company during the crucial growth phase
- Both SAFEs and convertible notes 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 and this also avoids any tax implications
- Convertible notes may require more negotiation upfront but be easier to roll out to investors as the terms will already have been negotiated whereas SAFEs tend to be negotiated for each investor
- The individual negotiation of a SAFE note allows the founders to test the market and make adjustments to terms as they go
- Convertible notes have been around for a very long time, they are a reliable funding method
- Convertible notes are less risky for investors as they are a debt with interest and an obligation to repay
- Both SAFEs and convertible notes may give the holders a liquidation preference, as discussed below.
- In terms of downsides of 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 conversion is exercised
- 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 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
- Convertible notes are a debt on which interest accrues and there is the potential of bankruptcy on default
- Incurring debt via a loan can be stressful for founders and lead to cash flow issues
- SAFEs are a relatively new funding method and so investors may not be comfortable using them yet and founders may struggle to attract the number or type of investors needed
- SAFEs do not have an obligation to repay and do not have a maturity date or interest and are therefore much risker for investors than convertible loans – this may put investors off at the early funding stage.
Converting to equity – pro forma to agree calculation methods
Because of the multiplier effect of SAFEs and convertible 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 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. We are happy to discuss this with you in further detail.
Other considerations when using SAFEs or convertible notes
SAFEs and convertible notes 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.
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.
A consequence of valuation caps may be to allow SAFE or convertible note 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/convertible note documentation and may include issuing a parallel series of preferred shares which reflect the actual price per share paid by the SAFE/convertible note holders.
In summary therefore, a SAFE is a form of convertible security in a simple document which gives holders the right to receive shares in the company at a discounted rate at the next fundraising round.
A convertible note on the other hand operates like a business loan with a maturity date and interest accruing but the debt is converted to shares upon certain trigger events (such a future funding rounds) rather than being repaid.
Both SAFEs and convertible notes 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 of your business and the type and quantity of investor you are seeking.