As a start-up founder, you have a number of potential equity deals available to you when fundraising and negotiating with investors. Two of these are the SAFE note and convertible notes. Both have much in common, but they also have their specific advantages and disadvantages.
In this article, I’m going to explore exactly what a SAFE note and a convertible note are, how they differ, and what sort of advantages they hold over each other.
What is a SAFE Note?
A SAFE note does not describe the inherent risk of using one, but is instead an acronym:
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The acronym itself describes what a SAFE note is supposed to accomplish. It was initially created in 2013 by Y Combinator, the same organization that created modern startup accelerators. The purpose of the SAFE note is to simplify equity agreements.
It is an agreement between an investor and a business owner, usually a startup founder or co-founder. This agreement is signed during an investment round, often in the pre-seed or seed stages.
A SAFE note protects the rights of both the investor and the entrepreneur, with clearly delineated rules for how equity should be treated when a subsequent funding round is entered. This is usually Series A funding.
When you sign this note as a start-up entrepreneur, it promises the investor a portion of shares at the next funding stage in return for immediate capital.
Essentially, a SAFE note stipulates the price and amount of future stock which the investor has rights to at a later date. At first glance, this looks like a standard debt for equity agreement, but a SAFE note is more akin to other equity instruments.
In the event that your company is liquidated, the investor who holds the note is not given priority for payment like some other creditors.
SAFE Notes Are Evolving
SAFE notes are relatively new, and so some changes have been made to them since their initial use just a few years ago. Y Combinator has continued to develop the SAFE note to include additional stipulations such as valuation caps, making them even more flexible but maintaining their simplicity.
There are now different versions of SAFE notes available to investors and startup founders. These include:
- SAFE: Valuation Cap, no Discount
- SAFE: Discount, no Valuation Cap
- SAFE: Valuation Cap and Discount
- SAFE: MFN, no Valuation Cap, no Discount
Some SAFE notes are also issued with a pro-rata side letter containing more in-depth legal stipulations.
What is a Convertible Note?
Like the SAFE note, convertible notes are used to promise investors that they will receive additional shares in the future. However, convertible notes are more like a form of short-term debt, with the investor loaning money to the company, including interest, with an option for equity at the next funding round.
When the next financing round is closed, the convertible note and its attached debt are then converted into preferred shares. Convertible notes are very similar to SAFE notes, however, they differ in that they:
- Include a deadline, also known as the maturity date, where the debt must be converted into equity or repaid regardless of the current value of the company.
- Are much longer than a SAFE note and are therefore more likely to be misunderstood by one or both parties.
- Have an interest rate attached so that the startup must pay this amount to the investor on top of converting the debt into equity at a later date.
The Advantages of a SAFE Note
SAFE notes have a number of advantages over convertible notes, including:
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1) They could be considered a warrant rather than debt.
2) There are fewer attached stipulations, keeping the agreement clear, concise, and easy to understand.
3) Lower complexity, meaning they don’t take long to process. This also means that, technically, no lawyer is required for a SAFE note to be interpreted. However, legal representation really should always be used.
4) Shorter documentation, taking less time to be read by investors and founders. More accessible.
5) No interest rate payments, meaning that founders can receive the same amount of investment as they would with a convertible note, but with a lower payment.
6) With no maturation date, a SAFE note is optional, meaning that both parties have to agree when it should be converted. This allows founders to hold off until a better time for the company.
The Advantages of Convertible Notes
While SAFE notes have recently been used as a replacement for convertible notes, they are not always preferential. Advantages of convertible notes include:
1) Convertible notes offer more control. More stipulations can be added, ensuring that the founder gets the exact deal they want, rather than the rather broad, simplistic deal offered by a SAFE note.
2) Because of their complexity, convertible notes are often used by seasoned entrepreneurs. By using a convertible note, an entrepreneur suggests implicitly to the investor that they are experienced.
3) The maturity date can have clear conversion stipulations attached to it, such as converting equity to shares or paying back the principal loan and interest. While the maturation date itself locks the founder into a schedule of conversion, they have more options over how that conversion is processed.
4) If you sign another SAFE note with an investor, this does not dilute the original note, meaning the SAFE noteholders get the same chunk of your company on conversion. However, convertible notes can dilute each other. That means the more investors you sign up to a convertible note deal, the smaller their actual stake will be at the time of conversion. This means the founder can get more investment for a smaller amount in their company. Especially if there is no valuation cap in place.
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