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!