Safe Passage: SAFEs vs. Convertible Notes

Raising capital from investors is often an important part of a startup’s growth plans. Just as important, however, is the question of just how much of the company the founder is selling to those investors. Pinning a precise value on a relatively new business can be a challenge, and valuation negotiations can slow down the financing process.

Both a convertible note and a SAFE (which stands for “Simple Agreement for Future Equity”) are flexible ways for a startup to raise money quickly and efficiently without needing to value the company today, which can be especially helpful when a business is in its early stages of growth.

Here are the key similarities, differences, and considerations to keep in mind about these instruments. In addition to the below, as always, tax is a major consideration when selecting the right form of investment to make or accept.

Overview

Convertible Notes

A convertible note is a type of debt instrument which can offer more options to investors than traditional debt. Like most debt, a convertible note usually provides for a principal amount, an interest rate, and a repayment date (or maturity date).

In addition, a convertible note provides for the principal and interest to be converted into equity (or shares) in the company. That conversion can be at the option of the debtholder, automatic upon certain events (such as a subsequent equity financing of at least a certain minimum size, or a sale of the company), or a combination of the foregoing.

The conversion price can be fixed in advance, or can be formulated based on the price used in the subsequent financing or other conversion trigger. In the latter case, the convertible note functions much like a SAFE, in which the future financing dictates the price to be paid by the investor for their shares.

SAFEs

SAFEs were first introduced by Y Combinator in 2013 as an alternative to convertible notes, and are now commonly used by the investment community, particularly in the technology sector.

At its core, a SAFE is an agreement whereby the investor provides funds to a company in exchange for a right to either acquire shares or other securities in a future priced offering by the company, or be paid out upon a liquidity event (such as if the company is sold or goes public).

Like convertible notes, SAFEs allow for capital raising without the need to value the company today. Unlike debt, there is no need to negotiate terms such as the interest rate or a maturity or expiry date.

Although they were ostensibly designed to be simple, SAFEs can be complex. Since they are not debt, they are not repayable, and if a conversion event or liquidity event never occurs, they may never produce the kind of tangible return most investors hope for.

Key Differences

Interest

Only convertible notes address interest because SAFEs are not debt instruments. The interest rate for convertible notes is subject to negotiation, and typically converts into equity together with the principal when a triggering event happens. An investor may need to report interest income in their tax filings.

Since SAFEs are not debt, they do not provide for interest, which means an investor’s potential ownership stake will not change based on how long a SAFE is outstanding.

Maturity Date

Only convertible notes have a maturity date. In contrast, a SAFE may be outstanding indefinitely and carries no requirement that funds ever be returned to investors or applied towards shares in the company, potentially leaving a SAFE holder in limbo without the prospect of any liquid return on their investment.

The maturity date for convertible notes is typically subject to negotiation. Often, a company will want to leave enough runway before the maturity date to conduct a subsequent financing, in order to prompt the conversion of the note.

If the maturity date arrives before a conversion event occurs, the company must either repay the loan or have the investor agree to an extension of the maturity date.

Security and Priority

Convertible notes may be secured or unsecured obligations of the company. If secured, the convertible note investor may have more downside protection in the event of an insolvency – and accordingly may be willing to invest on terms more favourable to the company.

Although SAFEs may contain terms requiring the holder to be treated similarly to a preferred shareholder upon a liquidation or winding-up of the company, even preferred shareholders typically rank behind creditors in priority of repayment, and so the convertible noteholder may stand a better chance of collecting some proceeds of the corporation in a bankruptcy – especially if the note was secured.

Tax and Cap Table Treatment

Although SAFE may be treated similarly to a warrant (a form of equity), whereas a convertible note may be treated as debt, a company should get tax advice before proceeding with any form of financing as the treatment of these instruments is not always clear cut.

Market Use

SAFEs may be more likely to be used by technology companies than by other forms of startups, and some investors may be less familiar with SAFEs as a result of their more recent innovation. Consider which kinds of investors you plan to approach as part of your decision about how to structure your financing.

Similarities

Valuation Cap

SAFEs typically feature a valuation cap, being the upper limit of a company’s valuation to be used in a future conversion of the SAFE into shares. Convertible notes can also include a valuation cap in their conversion mechanics.

Valuation caps help shield an investor from being excessively diluted if the company’s valuation increases significantly ahead of its next financing. Generally, the investor is entitled to convert their SAFE or note at the lower of (a) the valuation cap, or (b) the actual price per share used in the subsequent financing.

Valuation caps are often a key negotiation point for investors and companies alike. Lower caps benefit investors by setting the maximum price the investor can be required to pay for their shares upon a conversion. Higher caps usually favour founders, because the fewer shares a company needs to issue upon a conversion, the less dilution the founders experience.

For example:

• An investor might invest $100,000 into a company with 1,000,000 outstanding shares, using a SAFE or convertible note with a valuation cap of $1 million and no conversion discount (described below).
• Let’s imagine the company’s next financing is conducted at a valuation of $3 million, which implies a value of $3.00 per share currently outstanding.

Without a valuation cap, the original investor must also convert at $3 per share, and would receive 33,333 shares ($100,000 / $3.00).

But with a cap, the investor’s note or SAFE converts at $1.00 per share instead, and the investor receives 100,000 shares ($100,000 / $1.00). Under this scenario, the company must issue three times as many shares than if no cap was used, which dilutes the founders and other existing shareholders that much more, and can make it harder to incentivize new investors.

Conversion Discount

Both SAFEs and convertible notes may include a conversion discount in their terms.

A conversion discount is a lower share price applied when a SAFE or convertible note is converted into shares, as opposed to the price paid by the investors in the future financing. Paying less per share means that the investor who holds a SAFE or convertible note gets more bang for their buck in terms of equity – which can form part of the reward for investing earlier in the company’s development.

For example:

• An investor might invest $100,000 and receive either a convertible note or a SAFE with a 20% conversion discount on the company’s next financing.
• If the company’s next financing is conducted at $1.00 per share, the investor’s holdings will convert at only $0.80 per share (being $1.00 less 20%).

Instead of 100,000 shares, the investor would receive 125,000 shares on conversion (being $100,000 divided by $0.80). And again, the founders and other existing shareholders are correspondingly diluted.

Conversion Events and Early Exits

Both SAFEs and convertible notes typically have provisions that address payouts and conversions when the company concludes a subsequent equity financing of certain minimum characteristics, or undertakes a corporate transaction such as a sale, IPO, or change in control.

Typically, SAFEs provide that on a dissolution of the company, the SAFE holder is entitled to receive the full purchase price of their SAFE prior to any payments to the shareholders or other equityholders of the company.

Since convertible notes are not as standardized, the payout options may be more variable.

Key Considerations for Founders

If you are a founder, here are some key considerations as you plan for your raise:

• How much capital are you looking to raise, and how much of the company are you willing to sell?
• Who are your target investors, and how much might they be willing to invest?
• What form should the financing take – for example, an offering of shares at a fixed price, or instruments such as a convertible note or a SAFE? Get tax advice about what makes most sense for your company and any corresponding obligations such as tax filing requirements that are involved.
• If the investment will be made by way of a convertible note, what should the interest rate and maturity date be? When setting the maturity date, consider how much time you may need to build up your business and close a subsequent financing to help position you to pay off or convert the note in a timely manner.
• If the investment is by way of a SAFE, what should the valuation cap be? A higher cap minimizes dilution for the founders, and a lower cap benefits the investor.
• Which kinds of events should trigger conversion? Should there be optional conversion by the holder?
• Should there be a conversion discount, and what should it be?
• What should be the payout on a liquidity event such as a change of control?
• If you plan to issue a convertible note, consider if it will be secured or unsecured. If secured, will it be secured against only certain assets of the company, or against all of the company’s assets? Does your company already have any secured creditors (such as a bank) which may have restrictions on your company granting security to anyone else?

Key Considerations for Investors

If you’re an investor considering a SAFE or convertible note investment, here are some additional questions to keep in mind:

• Can you withstand the loss of this investment, or (similarly) a waiting period that may be indefinite? A SAFE may never be converted into shares or produce a cash return, and there may be no proceeds left for you after paying off creditors if the company goes under.
• How do you expect to make a return on this investment? Do you want the funds to be paid back? Or will your return be in the form of dividends or proceeds from a sale of the business? Keep in mind that startups may not issue dividends, and even if they do, you may not be entitled to receive them if you are not a shareholder.
• Even if a convertible note is secured, certain enforcement steps may be required in order to realize on the collateral that secures the debt. Are you prepared to take those steps and incur the associated expenses?
• Many corporate law entitlements apply only to shareholders. Which kinds of rights and protections are important to you? Consider rights to have a board seat, to subscribe for additional shares in future financings, to receive any more favourable terms granted to other investors, and to regularly receive financial statements, among others.
• Consider running due diligence searches against the company and its founders, such as lien searches to see if there are any other secured creditors already in the picture, and litigation and bankruptcy searches to confirm the company is not facing any proceedings.
• In case your investment is ultimately converted into shares, many other diligence questions may become relevant. For example, is there a shareholder agreement in place, and what obligations and requirements does it impose on you? Which other classes of shares has the company issued, and what entitlements do they have? Consider putting a shareholders’ agreement in place at closing that reflects the terms of your deal.