Category Archives: Startup Investment

Convertible Note SAFE

Convertible Note and SAFE Overview

Startups commonly raise money through one of two instruments: (1) Convertible Note; or (2) SAFE (Simple Agreement for Future Equity).  While these instruments are common, founders need to understand the basics of each instrument and the points of negotiation available.  This overview is part 1 of a 4 part series that, in future instalments, will cover negotiating each type of instrument and consider an alternative to these instruments.

Why use a Convertible Note or SAFE?

The Convertible Note and SAFE allow a startup to raise money without determining a value for the company.  Many early-stage companies do not or cannot determine a company valuation, especially those companies that are pre-launch, yet need to raise money.  These instruments are used to raise money but kick the question of valuation down the road until a future round values the company, otherwise known as a “priced round”.  Among startups, a priced round typically occurs with a Series-A financing, which involves issuing preferred shares to investors.

It’s important to understand that, under either instrument, equity is not initially issued to investors.  Instead, the instrument converts in the future into equity once the company raises a priced round, thereby establishing a company valuation at which the instrument can be converted.

NOTE – It is possible for startups to raise in priced rounds from day 1, a topic I will discuss in the final part of this series.

What is the difference between a Convertible Note and a SAFE?

A Convertible Note is a debt-equity instrument and, accordingly, charges interest while a SAFE is an equity instrument.  The interest element to the Convertible Note was part of the reason for the shift to SAFEs as this element created, in some situations, unnecessary legal issues.

From a negotiation standpoint, the instruments vary in the different elements commonly subject to negotiation.  A Convertible Note involves, at a minimum, discussions around: cap, discount, interest and maturity date .  Conversely, a SAFE usually involves one point of negotiation: cap.  This single point of negotiation has led to increased use of the SAFE over the Convertible Note.

These instruments also differ in how they convert.  A SAFE only converts upon a preferred share financing round (a priced round), which usually is a Series-A financing.  If a preferred share round does not occur then the SAFE remains unconverted and no shares are issued to the SAFE holder.  Conversely, a Convertible Note converts upon either a priced round (may not be preferred, depends on the note) OR at its maturity date.  As a result, a Convertible Note will always convert while a SAFE may not.

NOTE – there are additional points that can be negotiated on both Convertible Notes and SAFEs, for example, a discount or preemptive rights.

What is a Cap, Discount, Interest and Maturity Date?

Cap:  the maximum value at which the instrument converts into equity.  If the priced round values the company below the cap, the instrument converts at the priced round value (perhaps with a discount) and if the priced round values the company greater than the cap, the instrument converts at the cap value.  For example, if a company raises a priced round valuing the company at $12 million and a SAFE has a $10 million cap, the SAFE converts at a $10 million valuation.  It is possible for Convertible Notes and SAFEs to be issued without a cap, meaning that they convert at the priced round valuation, perhaps with a discount.

Discount:  discount an investor receives on conversion of the instrument, which may only occur upon particular conversion scenarios.

Interest:  Convertible Notes have a debt element and, accordingly, charge interest to the company issuing the note.  Interest is calculated into the total value of the Convertible Note upon conversion.

Maturity Date:  the date on which a Convertible Note must have converted by and, if no conversion has occurred, the note automatically converts on the maturity date.

Overall, Convertible Notes and SAFES are similar in the goal each instrument tries to achieve: raising money without determining a company valuation.  While similar in goal, each document has its own negotiation points, which will be covered in our next blog posts.  Stay tuned!

Investors don’t care where your Startup is Incorporated

Many founders I speak with are concerned about where their startup is incorporated and how this could impact fundraising opportunities in the United States.  In reality, this concern is unfounded.

Any sophisticated investor considers the product/service, team, market potential and other commercialization factors before, if at all, considering where a startup is incorporated.  In some circumstances, an investor may request that the startup alter its jurisdiction of incorporation but whether or not they proceed with the investment is determined 90% by quality of the company over jurisdiction of incorporation.  As relayed to me by Canadian founders, “if an investor passes because you’re a Canadian company, that’s not the real reason for passing“.

Where an investor requires your startup to be incorporated in the U.S. there is a simple process for creating this structure that I discussed in a previous blog post – The Canadian-U.S. Swap: Moving an Early-Stage Startup to the U.S.

Canadian founders should focus on building a compelling product/service and not waste energy worrying about minutia of incorporation.  Sell investors on your company and any issues concerning where your company is incorporated can be worked out between your legal counsel and investors.

Revisiting “Should I Incorporate my Canadian Startup in Delaware?”

It seems Canadians are still wrestling with whether to incorporate their startup in Delaware.  I wrote about this question back in September 2014  and since then the post has racked up over 1,000 views.  Back then, I concluded with this piece of advice, which I still stand by:

Don’t lock yourself into Delaware before you know where your investment comes from.  Based upon the cost and complexity of operating a Delaware startup from Canada, I recommend that you incorporate in Canada at the start.  Where a future U.S. investor requires you to incorporate in Delaware (or another state) your legal advisors can assist with this transition.  Conversely, Canadian investors may prefer to invest in a Canadian company!

Tip:  your product/service is important, not the place of incorporation.

Fully-Diluted Calculations

Congratulations, you received a term sheet!  While the main terms, such as valuation, are certainly important, there are numerous less noticeable terms that can have just as great an impact.  One such term is “fully-diluted”.

What is a fully-diluted calculation?

A fully-diluted calculation assumes that all options, warrants and other rights to acquire stock have been exercised or converted, regardless of whether they are actually vested or exercisable at the time of the offering.

Let’s illustrate the impact of a fully-diluted calculation compared to a funding round without full dilution.

Startup has issued 1,000,000 shares and 100,000 options.  None of the options are vested.  Investor desires to take 10% interest in the company.

Not fully-diluted:  Startup will use the number of issued shares only to calculate the 10%  and will issue investor 111,100 shares (representing 10%).

Fully-diluted:  Startup will use the total number of issued shares and options to calculate the 10% and issue the investor 122,200 shares.  However, since none of the options are vested, and may never vest, investor actually acquired a present-day interest of 10.89%.

While the above example seems benign given the .89% difference, that percentage could be worth a large sum if the company exits in the future.  What if you are selling an almost controlling interest in the company, perhaps 23.5%?  In that case, a fully-diluted calculation could result in a sale of a 25%+ (and controlling) present-day interest depending on the number of outstanding options etc.  In other situations, an investor may request that the entire option pool (even if no options have been granted) be factored into the fully-diluted calculation – in the case of a 12% option pool, this term would have a substantial impact.

In sum: while you may not be able to avoid a fully-diluted calculation in a term sheet, it’s important to understand its impact and to negotiate with that impact in mind.