Key Differences Between SAFEs and Convertible Notes

Startup investing and funding is challenging but essential for any founder. Since most early-stage startups aren’t yet profitable and self-sustaining, companies need to look for external sources of financing. This includes angel investors, venture capital firms, and even friends and family.

One increasingly popular form of startup funding is a convertible note, which combines aspects of both debt and equity financing. But what is a convertible note?  A convertible note is a short-term debt instrument that automatically turns into equity when a predetermined milestone or conversion event occurs. Essentially, a convertible note functions like a business loan that converts into equity instead of being repaid..

So what are the benefits of a convertible note vs equity, and what are the key differences between convertible notes and SAFEs (another fundraising instrument)? Find out below.

How do convertible notes work?

It’s important to understand how convertible notes work. Traditionally, investors know a startup’s valuation before a fundraising round because the valuation determines how much equity they receive. However, if the business is too new for an accurate valuation, this may be difficult or impossible to determine. 

Convertible notes help solve this dilemma by using the concept of “convertible equity.” Convertible notes can be issued during the pre-seed or seed funding stage. They can then be converted into equity once the company has a valuation (e.g. during Series A fundraising).

Here are some crucial terms for understanding convertible notes:

• Interest rate: Convertible notes function as a debt instrument. They have an interest rate attached like any other loan. However, in this case, the “interest” is paid in the form of business equity, rather than cash. That means investors receive a greater number of shares upon the note’s conversion than they would have received from their initial investment.
• Discount rate: Investors who provide startup funding in the form of convertible notes receive a discount when buying shares later. For example, if the discount rate is 30 percent and the company later sells shares for $10, convertible note investors can purchase shares at a rate of $7 instead.
• Valuation cap: Convertible note investors are also rewarded for taking on risk in the form of a valuation cap. This figure is an upper limit on the company’s valuation when the convertible note turns into equity. For example, if the company is valued at $5 million but the valuation cap is $1 million, investing $100,000 will give 10 percent equity in the business.
• Maturity date: The maturity date of a convertible note is the final day by which the business either needs to repay the loan or extend the agreement.

Pros:

• Flexibility for Startups: Delays setting a company valuation, allowing more time for growth before locking in a price.
• Easier and Faster Fundraising: Less complex than formal equity rounds, speeding up the fundraising process.
• Investor Protection: Acts like a loan with interest, offering some downside protection in case the company struggles.
• Potentially Lower Dilution: Investors convert to equity at a potentially higher valuation, reducing ownership stake given up by founders.

Cons:

• Potential Cost for Startups: Interest accrues on the note, adding to the cost if converted at a high valuation.
• Less Control for Investors: No voting rights until conversion, limiting investor influence.
• Potential for Anti-Dilution Protection: Investors may negotiate features that make conversion cheaper if the company raises future funds at a lower valuation.
• Uncertainty for Both Sides: Valuation at conversion can be a point of contention for founders and investors.

How equity works

Startup equity offers a way for founders, employees, and investors to share ownership in a company. It can also be used to compensate advisors. This can be a powerful motivator, but it also comes with complexities. Here’s a breakdown of the pros and cons:

Pros:

• Alignment of Interests: When stakeholders own a piece of the company, their success becomes financially tied to its success. This can create a strong sense of ownership and drive everyone to work towards the same goal.
• Attracting Talent and Capital: Equity can be a valuable form of compensation, especially for early employees who might be taking a risk on a new venture. It can also be attractive to investors who see the potential for high returns on their investment.
• Expertise and Networks: Angel investors and venture capitalists often bring not just money, but also valuable business experience and connections. This can be a huge benefit for young startups.

Cons:

• Loss of Control: Founders who give away too much equity can dilute their voting power and decision-making authority. This can lead to disagreements with investors or even situations where the founders are pushed out of the company.
• Potential for Conflict: Equity distribution can be a complex and sensitive topic. Disagreements over percentages or valuation can lead to internal conflict and hinder the company’s growth.
• Long-Term Commitment: Equity isn’t usually liquid cash. Investors and employees may be locked into the company for a long period before they can see a return on their investment.

Additional Considerations:

• Equity Distribution: The amount of equity given out is based on factors like timing, contribution, and company valuation. Founders typically get the most, followed by early investors and employees.
• Funding Stages: Equity distribution often changes with funding rounds. As the company raises more money, the ownership percentages of earlier stakeholders are diluted.

By understanding both the advantages and disadvantages of startup equity, founders can make informed decisions about how to structure their ownership and incentivize key players.

How does SAFE work

SAFE (Simple Agreement for Future Equity) stands for exactly what it sounds like – a streamlined agreement that grants investors the right to purchase shares in a company at a future date. Developed by Y Combinator, a prominent Silicon Valley accelerator, SAFEs were created specifically to address the challenges faced by startups in the crucial seed funding stage. These early-stage companies often haven’t established a clear valuation yet, making traditional equity financing a cumbersome process. SAFEs offer a solution by postponing the valuation discussion until a later funding round, allowing startups to focus on growth and secure capital quickly.

Here’s a breakdown of the pros and cons of using SAFEs for seed investment:

Pros:

• Simpler and Faster: Compared to convertible notes, SAFEs offer a quicker and less complex fundraising process by delaying valuation discussions until a later funding round.
• Flexibility for Startups: Founders can defer setting a company valuation, allowing more time for growth before locking in a price.
• Potential for Lower Dilution: With a valuation cap, SAFE investors pay a maximum price for shares, potentially giving founders a better deal if the company’s valuation increases significantly.
• Priority in Liquidation: In case of company dissolution, SAFE investors receive their investment back before common shareholders.

Cons:

• Limited Investor Rights: SAFE investors typically have no voting rights or board representation until conversion, offering less control compared to traditional equity.
• Potential Cost for Startups: If the company experiences high growth and a subsequent funding round has a much higher valuation, the discount rate on the SAFE might not be enough, leading to a higher cost for the company.
• Uncertainty for Both Sides: The conversion valuation can be a point of negotiation, potentially causing friction between founders and investors.
• Potential Conversion Issues: The SAFE may not convert into equity if there’s no future funding round or acquisition.

Comparing Convertible Notes, Equity, and SAFEs

Choosing the right financing instrument for your startup is crucial. Each option offers distinct advantages and disadvantages depending on your company’s stage, funding goals, and risk tolerance. This guide will break down the key differences between convertible notes, equity, and SAFEs to help you determine which one best suits your needs.

Convertible Notes vs. Equity vs. SAFEs: A Side-by-Side Comparison

By understanding the characteristics of each instrument, you can make an informed decision. Convertible notes offer flexibility for startups with potential downside protection for investors. Equity provides investors with the most control but comes with the risk of dilution for founders. SAFEs offer a balance between the two, with a focus on simplicity and potential benefits for both founders and investors. Consider your company’s specific needs and risk tolerance when selecting the most suitable financing option.

Convertible note vs. equity

When it comes to convertible notes vs. equity, which fundraising option should startups use? Here are the factors to consider in convertible debt/equity financing:

• Costs: Equity financing is often less expensive to the business than convertible notes. As discussed, convertible note investors are compensated for the higher risk profile in the form of discount rates and valuation caps.
• Ease of fundraising: Equity financing is the traditional form of startup fundraising, so it will likely be easier to generate investor interest. However, some knowledgeable investors with an appetite for risk may prefer a convertible note arrangement.
• Ease of use: Convertible notes are generally simpler to execute than equity financing. Convertible notes can be issued in a matter of days (and with little legal red tape). However, negotiating and implementing equity financing is significantly more complex and time-consuming.
• Loss of control: Many equity investors want to have a hand in directing the business. This includes occupying a seat on the company’s board. Convertible note investors, on the other hand, generally have no such expectations. This can be appealing for startups that want to retain more control.

SAFE vs convertible note

SAFE (simple agreement for future equity) notes were first created by the startup accelerator Y Combinator in 2013. The main difference between a SAFE note and a convertible note lies in the S: “simple.”

Like convertible notes, SAFE notes are intended to be converted to equity at a later date. However, SAFE notes contain several modifications that are intended to simplify the traditional process of convertible equity financing.

Most importantly, unlike convertible notes, SAFE notes are not a loan or a debt instrument. This means that they lack a defined maturity date or interest rate. As such, there is no time pressure for the company to convert the SAFE note into equity during a fundraising round.

The considerations when it comes to SAFE notes vs. convertible notes for founders and investors include:

• Conversion event: SAFE notes automatically convert into preferred stock during the company’s next fundraising round. However, convertible notes may have a variety of possible conversion events. These include when the startup raises a given amount of money, or even when the two parties agree on the conversion.
• Speed: Due to their streamlined nature, SAFE notes are even easier to issue than convertible notes. This may be a significant benefit for businesses that want to get up and running quickly with funding.
• Investor preference: SAFE notes are increasingly popular, particularly among tech startups. However, some investors prefer to stick with convertible notes or traditional equity financing.
• Investor risk: SAFE notes lack a maturity date or interest rate, which can frustrate investors waiting to convert them into equity. In addition, if the SAFE note has a valuation cap but no discount rate, investors may not see any benefit from signing up early.

Should startups choose SAFEs, equity or convertible notes?

Choosing between SAFEs, convertible notes, and equity depends on where your startup is in its journey and what your priorities are. Here’s a breakdown to help you navigate this decision:

Early Stage and Focused on Growth (Seed Funding):

• Consider a SAFE: If you’re a very early-stage startup with a focus on rapid growth, a SAFE might be ideal. It allows you to raise capital quickly and defer valuation discussions until a later funding round when you have a clearer picture of your company’s worth. Investors benefit from the potential for a lower purchase price on equity if the company takes off. However, SAFEs offer them less control and potential return compared to other options.

Balancing Flexibility and Investor Protection (Seed or Series A):

• Explore Convertible Notes: Convertible notes offer a middle ground. They provide some protection for investors through interest payments and the potential for higher returns if the company experiences a significant valuation jump. Additionally, they offer flexibility in terms of the amount raised at once. However, the debt nature of convertible notes can add complexity and legal fees. Founders should be aware of potential dilution if the company raises money at a lower valuation before conversion.

Established Startup with Clear Valuation (Series A or Later):

• Equity Financing Might Be Best: For established startups with a proven track record and a clearer valuation, traditional equity financing might be the most suitable option. It offers investors the most control through voting rights and board representation. However, this also means founders give up a larger ownership stake, leading to potential dilution as the company grows. Equity financing can also be a more complex and time-consuming process compared to SAFEs and convertible notes.

Remember:

• Talk to Investors: Ultimately, the best option often comes down to what your investors are comfortable with. Open communication about your company’s goals and their expectations is key.
• Consider Legal Advice: While SAFEs are generally simpler, consulting a lawyer can be helpful for navigating the specifics of any financing agreement, regardless of the chosen instrument.

Frequently Asked Questions

Do investors prefer SAFE or convertible note?

There’s no clear-cut answer. Investors with a higher risk tolerance might prefer convertible notes for the potential of higher returns due to interest and conversion at a higher valuation. However, some investors appreciate the simplicity and potential for a lower purchase price with SAFEs. Ultimately, it depends on the specific investor’s preferences and the stage of the startup.

Is a SAFE better or convertible note for a startup company?

For very early-stage startups, a SAFE can be advantageous due to its simplicity and focus on future valuation. It allows you to raise capital quickly and focus on growth. However, convertible notes might be better for companies needing more flexibility in terms of fundraising amount or wanting to offer some protection to investors through interest. Consider your priorities and discuss the options with your investors to find the best fit.

Are SAFEs equity or debt?

SAFEs are neither equity nor debt. They represent an option to purchase equity at a future date, typically during a qualified funding round.

What happens to convertible note if startup fails?

If the startup fails before a triggering event (like a funding round or acquisition), the convertible note holder becomes a creditor. This means they might be entitled to receive their investment back before common shareholders in a liquidation event, depending on the specific terms of the note. However, they wouldn’t own any equity in the company.

Is convertible note better than equity?

Convertible notes aren’t necessarily “better” than equity. They offer a way to raise capital without setting a company valuation upfront. This can be beneficial for early-stage startups. However, founders should be aware of potential dilution if the company raises money at a lower valuation before conversion. Equity provides investors with more control but comes with the risk of dilution for founders from the outset.

Do SAFEs have interest rates?

No, SAFEs don’t accrue interest like convertible notes. This can be a disadvantage for investors who miss out on potential returns while waiting for a conversion event.

From an investor’s perspective, what are the advantages to a SAFE over a convertible note for a seed stage investment?

For seed-stage investments, SAFEs can be attractive to investors because they:

• Simplify the investment process.
• Offer the potential for a lower purchase price on equity due to the valuation cap and discount.
• Provide priority in liquidation if the company fails.

However, keep in mind that SAFEs also come with drawbacks for investors, such as:

• No guaranteed conversion, potentially leading to lower returns.
• Less control over the company compared to convertible notes with voting rights.

Why should a founder avoid convertible notes above $1M?

There’s no hard and fast rule about avoiding convertible notes above a specific amount. However, with larger funding rounds, the potential drawbacks of convertible notes become more significant. Here’s why:

• Higher interest payments: Larger investments translate to potentially significant interest accrual if not converted quickly.
• Dilution risk: If the company’s valuation doesn’t increase significantly before conversion, founders might face higher dilution than with other options.

For larger funding rounds, exploring equity financing or convertible notes with a more founder-friendly structure might be a better option. It’s always best to consult with financial advisors and lawyers to determine the most suitable financing strategy for your specific situation.

Choosing the Right Path for Your Startup

The world of startup financing can seem complex, but by understanding the key differences between SAFEs, convertible notes, and equity, you can make an informed decision that aligns with your company’s stage and goals. Remember, the best option often hinges on open communication with your investors.

No matter which path you choose, navigating the startup journey is rarely a solo endeavor. Joining a community of passionate founders can provide invaluable support, tips from experienced mentors, and even potential funding connections. Surrounding yourself with others who understand the challenges and triumphs of building something from scratch can be a game-changer. So, as you choose your financing instrument, consider exploring the rich ecosystem of startup communities waiting to empower your entrepreneurial journey.

To learn more about startup investing and funding, see if you qualify for membership to join Founders Network.