Information Access Rights
Who can see what: directors’ and shareholders’ rights to corporate information.
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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 its founders are giving up in exchange for that capital. 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 (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 in the 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.
Below is a high-level overview of how convertible notes and SAFEs work, followed by a comparison of their key differences and similarities.
A convertible note is a type of debt instrument that can offer more flexibility 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. That conversion can occur at the option of the noteholder, automatically upon certain events (such as a later equity financing of at least a specified minimum size, or a sale of the company), or a combination of these mechanisms.
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 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 completes anIPO) typically on terms set out in the SAFE, which may provide for either a cash payout or conversion into equity.
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.
Only convertible notes address interest because SAFEs are not debt instruments. Interest under a convertible note is negotiable and typically converts into equity together with the principal upon a triggering event. An investor may also be required to report interest income for tax purposes.
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.
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 any iquid 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.
Therefore, a maturity date can act as a source of leverage if a subsequent financing does not close on schedule. As maturity approaches, investors may gain negotiating power to push for extensions or revised terms. Founders should realistically assess whether a maturity date aligns with their expected growth and fundraising timeline.
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.
Although a 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 asthe treatment of these instruments is not always clear cut.
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.
In practice, SAFEs are sometimes supplemented by additional agreements beyond the core SAFE document. Side letters may grant additional rights, such as the ability to participate in future financings on a pro‑rata basis. These rights can be commercially significant and may influence future rounds, particularly where they are held by multiple early investors.
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:
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 as would be issued 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.
Many SAFEs now use a post‑money valuation cap, which fixes the investor’s percentage ownership of the company at the time the SAFE is issued rather than at conversion. As a result, any additional SAFEs or convertible instruments issued before a priced round may dilute founders and other shareholders, but not earlier SAFE holders. Founders should be careful to understand how multiple post‑money SAFEs can stack and affect overall dilution.
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:
Instead of 100,000 shares, the investor would receive 125,000 shares on conversion (being $100,000 divided by $0.80). As with valuation caps, this results in additional dilution to founders and other existing shareholders.
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.
However, as multiple SAFEs or notes accumulate, modelling conversion outcomes becomes increasingly important, particularly when valuation caps differ.
Some SAFEs and convertible notes include a “most‑favoured‑nation” provision, which allows their holders to benefit from any more favourable economic terms granted to subsequent investors.
Most‑favoured‑nation clauses can help streamline early fundraising by deferring negotiations, but they can also introduce additional complexity if multiple instruments with different terms are ultimately issued.
In Canada, issuers must still ensure compliance with available securities law prospectus exemptions when issuing SAFEs or notes.
Choosing between a SAFE and a convertible note involves balancing speed, risk, and long-term dilution. Founders and investors should consider not only current economics, but also how these instruments will interact with future financings and exit scenarios.
If you are a founder, here are some key considerations as you plan for your raise:
If you’re an investor considering a SAFE or convertible note investment, here are some additional questions to keep in mind:
