The Hidden Risks Of SAFEs And Convertible Notes — For Both Sides!

Both investors and founders of early-stage startups should be aware of the hidden risks of SAFEs and convertible notes. Simple Agreements for Future Equity (SAFEs) and convertible notes are typically preferred instruments for raising funding for new companies.

Founders at the pre-seed or seed stages of building their companies may find it challenging to find investors. The lack of any collateral or other markers that signal the investment is safe is a major deterrent. Thus, if you need more capital, you’ll consider options that don’t involve a high valuation.

SAFEs and convertible notes enable you to raise the capital needed to take the startup forward. However, you should be aware of the potential risks and the impact on your ownership stake following subsequent funding rounds.

Not just founders but also investors hesitate to provide capital with these instruments. Given the high risk, they may seek tougher terms and conditions to secure their money and obtain payment assurance.

Before you agree to these terms, weigh the pros and cons, as well as the future complexities in the cap table. Working with an experienced fundraising consultant is advisable.

Let’s explore in detail the hidden risks of SAFEs and convertible notes. As a founder, you’ll also understand the investor perspective and why they hesitate to rely on these financial instruments.

Hidden Risks for Founders

When you need capital for your fledgling company, SAFEs and convertible notes can seem like viable options. Here’s a quick recap of the primary advantages of SAFEs for founders:

• You can raise funding without valuing the startup.
• No need to give up equity or controlling rights.
• You don’t pay interest, making them founder-friendly and flexible.
• If the startup fails, you’re not liable for loan payments.
• Easy to understand and organize, and incurs minimal legal costs.
• You don’t need to worry about the loan’s maturity dates.
• SAFEs don’t involve interest payments, which lowers the administrative burden on founders.
• If the company does not reach the pre-determined triggering event, SAFEs remain on the cap table as is. Investors can receive payment upon a liquidity event, such as an initial public offering (IPO) or an acquisition.

As for the primary advantages of convertible notes, here’s what you need to know:

• You can raise funding without valuing the startup.
• No need to give up equity or controlling rights.
• Although a debt instrument, you don’t need to repay if the company fails.
• Easily available, as the risk factor is lower.
• Maturity dates range from 12 to 24 months, which is the typical time frame before you raise a formal round.
• You’ll pay a lower interest rate than other lenders in the market. If the company performs well, you can repay the loan in cash.

Let’s talk about the hidden risks.

• SAFEs entitle investors to convert the instruments into equity if the company is successful. They can also convert the SAFEs into convertible notes if they anticipate significant returns.
• If you issue convertible notes, you’ll pay interest ranging from 2% to 8%, which accumulates on the principal amount. When the notes convert, you’ll give up more equity, resulting in greater dilution.
• The key difference between the two is that investors can choose to convert their SAFEs or purchase equity later. Convertible notes automatically convert into equity according to a pre-determined schedule.
• Notes include a pre-determined maturity event such as the next funding round. You can negotiate the maturity event and push it to 18 to 36 months. However, founders should be prepared for the possibility that the company fails to raise a qualifying round. In that event, investors can demand repayment of the convertible note, including accrued interest. This can potentially bankrupt the startup. Many notes include the option to extend the due dates, but investors must agree to the condition.
• Too many unconverted SAFEs on your cap table with varying terms can make it confusing and complex. Future investors analyzing the cap table might hesitate to invest because calculating equity and dilution becomes more complicated.
• Some investors may require a side letter with the SAFE that entitles them to more favorable terms than others. For instance, observer seats on the board, information rights, pro rata rights, optional conversion, and cap resets. The Most-Favored-Nation (MFN) clause could also be included in the side letter. This provision assures investors that they will receive terms comparable to those of other entities in similar transactions.

How SAFEs and Convertible Notes Impact Founder Equity

Equity dilution is among the most significant hidden risks of SAFEs and convertible notes. This is why founders should be cautious when accepting them. Here’s what you need to know:

• Many founders consider leveraging the flexibility SAFEs offer, as they don’t need to worry about interest payments or maturity dates. However, this also means that SAFEs are a “sleeping” instrument. If you don’t manage them effectively, you could end up forking over a substantial ownership stake when they convert into equity.
• Issuing too many SAFEs makes it difficult for founders to track the equity they may need to give up. By the time they raise a qualifying round, their ownership equity could be significantly depleted.

Keep in mind that storytelling is everything in fundraising. In this regard, for a winning pitch deck to help you here, take a look at the template created by Peter Thiel, Silicon Valley legend (see it here), that I recently covered. Thiel was the first angel investor in Facebook with a $500K check that turned into more than $1 billion in cash.

Remember to unlock the pitch deck template that founders worldwide are using to raise millions below.

How Valuation Caps Work

When issuing SAFEs or convertible notes, it’s crucial that you understand how valuation caps work. A valuation cap determines the maximum company valuation at which the notes will convert into equity. You’ll use this provision when calculating the price per share on conversion.

Valuation caps reward early-stage investors for the higher risk they assume when investing in a startup by allocating equity. They’ll receive more equity if the company has a significantly higher valuation before the first priced round. Typically, the Series A is the first such round.

• If the company’s valuation exceeds the cap, investors receive shares priced at the cap rather than at the round’s actual valuation. As a result, they receive more shares because the share price is lower.
• If the company’s valuation is at or below the cap, investors receive shares at the actual round value. The cap value becomes immaterial, but the discount rate will apply. Under the discount rate provision, investors can acquire shares at prices below market value.
• Most SAFEs include the “lower of” valuation provision, which combines the valuation cap and the discount rate. Under this provision, investors can use whichever option offers the lower price per share. In this way, they can maximize their equity stake.

Founders should be cautious about the valuation caps they set when issuing SAFEs. If caps are too low, conversions can result in significantly higher dilution. You’ll give up higher equity and ownership stakes to your investors, which ultimately leads to a loss of control.

Let’s try an example.

Let’s assume an investor invests $100K in a startup via a SAFE at a valuation cap of $5M. Here’s what happens:

• Scenario 1 – The company raises its first funding round at a valuation of $10M. Accordingly, the SAFE converts at $5M since the cap applies, and the investor receives a 2% ownership stake. Here, $100K / $5M = 2%.
• Scenario 2 – The company raises its first funding round at a valuation of $5M. The same rule applies, and the investor receives a 2% ownership stake. Here again, $100K / $5M = 2%.
• Scenario 3 – The company raises a down round at a $3M valuation. At $3M, the investor receives a 3.3% ownership stake. Here, $100K / $3M = 3.3%.

How Pre-Money and Post-Money Valuation Caps Work

A more critical distinction to understand is how pre-money and post-money valuation caps work. These calculations are another of the hidden risks of SAFEs and convertible notes.

• A pre-money valuation cap calculates the SAFE investor’s ownership before factoring in the new capital and before you convert other SAFEs. Here, the numerator in the conversion price calculation increases by the value of the convertible securities that are converting. As a result, the SAFEs dilute one another.
• A post-money valuation cap calculates the SAFE investor’s ownership after factoring in all other SAFEs. Each investor receives a fixed ownership percentage. This mechanism results in the founder carrying the maximum dilution. Here, the numerator in the conversion price is fixed.

Most founders mistakenly assume that if they raise $1M at a $10M valuation cap, they are giving away 10% of their company. This assumption holds only for a post-money valuation cap. Here, investors receive a 10% equity stake prior to the next equity funding round.

However, for the pre-money valuation cap, dilution depends on the total outstanding SAFEs and convertible notes. Accordingly, investors receive a 9.09% ownership, which works out to $1M/$11M.

Post-money valuation caps provide investors with greater safeguards by guaranteeing a fixed ownership percentage. Accordingly, if you’ve issued a substantial number of SAFEs at a low post-money cap, SAFE holders will receive a significant portion of the pre-money cap table.

If that happens, the founders’ ownership stake decreases. This is why, despite the advantages of SAFEs and convertible notes, founders should be cautious about the potential dilution they entail.

An early growth stage company may not feel the impact. But the shifts in ownership stakes can quickly stack up as you raise further funding rounds.

Working out your pre-money valuation vs. post-money valuation can be complicated. If you need help with understanding how it works, check out this video I have created.

Hidden Risks of SAFEs and Convertible Notes for Investors

From the investor’s perspective, the biggest risk is backing a startup with seed capital. They receive no collateral except for the option to convert their instruments into equity. These conversions are subject to different terms and conditions that both parties negotiate aggressively.

• SAFEs don’t have any maturity dates or interest rates. This means investors may have to wait indefinitely to see any meaningful returns. Typically, startups don’t have any timeline before they raise a priced round. Further, the possibility of the investment failing entirely is very real.
• Given a choice between pre- and post-money valuation caps, investors prefer the latter. This mechanism entitles them to a fixed percentage of the equity stake, providing some clarity.
• Each time the startup issues new SAFEs and convertible notes, the cap table can become more complex. This situation can lead to disputes between founders and investors, particularly when their stakes are diluted significantly.
• If the valuation caps are too high, achieving milestones can be challenging for the startup. This, in turn, impacts its ability to raise further funding.
• Accepting valuation caps does not necessarily work well for investors. If the startup delivers exceptional performance, it will command a higher valuation at the time of the priced round. Investors can miss out on potential earnings due to caps.

Considering the many downsides, investors are increasingly wary of startups issuing SAFEs and convertible notes. Even if they do provide capital via these financial instruments, they require several clauses and provisions in the side letters.

Investor Safeguards

One investor safeguard you can offer against the hidden risks of SAFEs and convertible notes is Major Investor Rights. This provision creates a special category of investors and grants them specific rights upon conversion of their SAFEs into equity.

These rights include pro rata rights, information rights, and Most-Favored-Nation (MFN) protection. Some investors may also require the right to approve or veto key corporate actions and decisions. Or, to convert their SAFEs into preferred shares.

The Major Investor Rights provision can also extend rights beyond the next priced funding round, after which they should terminate. On their part, founders should be cautious about agreeing to such conditions — particularly, if they also include board observer rights and access to information.

You could also require that the special rights terminate upon the Series A milestone. Ensure that the size of the check and its strategic value justify the rights you’re offering. You’re looking for lead investors and tactical partners that can drive the startup forward.

The Takeaway — Create an Optimum Balance

SAFEs and convertible notes offer several benefits for early-stage startups seeking capital to get off the ground. At the same time, be wary of the dilution these instruments entail as additional funding rounds accumulate. Ensure you retain control over decision-making.

Work with expert consultants who can advise you on the long-term impact of every SAFE or convertible note you issue.

You may also find our free library of business templates interesting. There, you will find every single template you need to build and scale your business completely, all for free. See it here.