For startup founders and investors in startups alike, navigating the world of financing can be tricky. Two popular instruments used to raise early-stage capital are SAFEs (Simple Agreements for Future Equity) and convertible notes. How do they differ? And in what circumstances may one be better than another? This determination will vary depending on whether you are an investor or a founder.
Both instruments provide a flexible approach to funding but differ in their respective structure and implications. Understanding these differences can help you make informed decisions that align with your startup’s goals or decide how to invest in what may be the next unicorn.
Structure and Nature of the Instruments
SAFEs:
As the name suggests, a SAFE is a simple agreement that gives an investor the right to future equity. Unlike convertible notes, SAFEs are not debt instruments, meaning they do not carry an interest rate or a maturity date. Instead, the investment is converted into equity at the next qualifying funding round based on a pre-agreed valuation cap or discount rate.
Convertible Notes:
Convertible notes are essentially short-term loans that can convert into equity. They carry an interest rate and a maturity date, meaning the startup must either repay the note or convert it into equity by an agreed date. The conversion terms often include a valuation cap and/or discount rate.[i]
Investor Risk and Control
SAFEs:
Investors in SAFEs take on more risk because the instrument lacks a repayment obligation or interest. They rely on the startup successfully raising additional funds to trigger conversion into equity.
Convertible Notes:
With a set maturity date and interest, investors have more control and a safety net. If the startup cannot raise additional funds by the maturity date, the investor may demand repayment or renegotiate terms, offering more leverage.
Founder Perspective
SAFEs: Founders may prefer SAFEs because of their simplicity, lower administrative burden, and absence of looming repayment obligations. This allows them to focus on growing the business without the stress of maturing debt.
Convertible Notes: Founders need to be more cautious with convertible notes due to their debt nature. They should be prepared for repayment or renegotiation, which could become a distraction or source of tension if the note matures before new funding is secured.
I. Use Cases
SAFEs:
Best suited for startups seeking quick and straightforward financing, particularly during early fundraising rounds where valuation might not be crystal clear.
Convertible Notes:
More fitting when investors desire some level of protection or when a business is mature enough that debt can be managed.
II. Advantages of Convertible Notes for Founders
Speed and Simplicity: They can be quickly executed with simple terms, allowing founders to focus on the business rather than extensive fundraising negotiations.
Potential to Delay Valuation: They offer founders the flexibility to delay formal valuation until a later stage. This provides more time to prove business metrics and potentially secure a higher valuation.
Market Validation: The presence of a maturity date creates urgency for fundraising, prompting founders to identify their market positioning and refine their business models quickly. This is arguably an advantage.
III. Advantages of SAFEs for Founders
No Debt Repayment Obligation: Without interest rates or maturity dates, SAFEs allow founders to focus on growing the business without the stress of immediate repayment.
Administrative Simplicity: As a straightforward instrument, SAFEs (like convertible notes) reduce the administrative and legal burden associated with more complex investment structures for startups.
Investor Alignment: With pre-negotiated conversion terms and the potential for higher returns, SAFEs attract investors seeking aligned incentives and a streamlined investment process.
IV. Advantages of Convertible Notes for Investors
Downside Protection: As debt instruments, convertible notes offer a safety net through interest rates and maturity dates. If the startup falters, investors can demand repayment or negotiate new terms.
Prioritized Claims: Convertible notes give investors a higher claim in case of liquidation or bankruptcy, reducing the risk relative to common stockholders.
Early Equity Participation: Investors gain access to equity at a discounted rate during subsequent funding rounds. This provides potentially higher returns.
V. Advantages of SAFEs for Investors:
Lower Administrative Burden: SAFEs have fewer legal complexities, meaning investors can quickly negotiate terms and move forward with investment opportunities.
Potentially High Returns: With a pre-negotiated discount or valuation cap, investors can achieve attractive equity positions in future funding rounds. This is especially true if the startup scales significantly.
Founder Alignment: By not requiring immediate repayment, SAFEs incentivize founders to focus on building a successful business rather than servicing debt. This aligns interests with investors.
Conclusion
Both SAFEs and convertible notes have their merits and drawbacks, depending on your startup’s stage and the preferences of the investor. By understanding their core differences, you can make strategic decisions that attract the right partners and accelerate your journey toward business growth. If you are unsure which instrument is the best fit for your situation, contact us and let us guide you through this crucial step in your financing journey.
[i] A valuation cap is like a ceiling that limits the maximum value at which early investors will convert their investment into shares when a startup raises its next round of funding. It ensures that early investors get more shares if the startup's valuation increases significantly, giving them a better deal and more ownership in the company. Essentially, it's a way to reward early investors for taking on the risk of investing before the company was well-established.
A discount rate is a percentage off the price that early investors get when their investment converts into shares during the next round of funding. It acts like a coupon, allowing them to buy shares at a lower price than new investors will pay. For example, if a startup offers a 20% discount rate and new investors buy shares for $5 each, early investors will only need to pay $4 per share.
Article by R Tamara de Silva