SAFE Notes Vs Convertible Notes
Last Updated: 2/7/2022
Convertible Notes and SAFE Notes relate to the seed funding round for entrepreneurs. Although they are similar in nature, a few differences make it worthwhile for the new company to give consideration to various aspects before deciding which option to choose among various financing instruments available to them during various rounds of financing.
Definition
SAFE Notes stand for “simple agreement for future equity notes”, which are a way for entrepreneurs to raise seed money for their startup. SAFE Notes are the documents, usually less than five pages, which legally allow investors to buy some shares of the start-up in the future where both the number of shares and price are specified.
A convertible note is a type of investment vehicle with a structure resembling that of a loan. From the point of view of a start-up, it is a form of debt that entitles the investors, the right to convert into equity when you hit an agreed-upon milestone. Convertible note automatically changes into shares of preferred stock upon the closing of a Series A round of financing.
SAFE Notes are essentially a type of Convertible notes that help startups raise money for scaling their business. Both will eventually be converted into equity; however, they are both different from each other in a way that Convertible Notes are more complex as they are a form of debt, which can be converted into equity after completion of certain milestones. As they are a form of debt, they carry an interest rate as well as a maturity rate.
Y Combinator, a silicon valley startup accelerator introduced a simple agreement for future equity (SAFE) as an alternative to convertible notes, to allow startups to raise seed money without interest rates and maturity dates.
In this article, we will focus on how SAFE notes work, their types pros/cons of using them, and compare these aspects of SAFE notes with Convertible Notes.
When a new business starts, its valuation is usually difficult. At this time, SAFE Notes become usable. This document helps the startup to get money from the investor by allowing them to raise money based on “promised future equity”. Afterward, when the company uses this seed money to grow the business, it can get “post-money valuation” through another investor. As a result, we obtain the “price per share” of the company that is used to convert the SAFE Notes into the applicable number of shares that are then distributed to the seed investor.
Post-money valuation is the amount that a company raises as a result of investment in exchange for equity. Any prior valuations of the business may not matter once the company raises outside funds from investors.
Elements of SAFE Notes:
Here we discuss some terminologies related to SAFE Notes that will be helpful in understanding the various different ways in which SAFE Notes can be converted into equity.
1. Valuation Cap
A valuation cap is used to set the highest price or cap that can be used at the time of conversion price setting. It is a useful tool for the initial investors to obtain a better price for their shares as compared to the investors who will be investing in the future.
The higher the valuation cap, it will mean there will be more expensive investment by the investor for the same level of ownership. Henceforth, it results in dilution from the investor’s perspective. If the valuation of the company in subsequent funding rounds exceeds the valuation cap, safe holders will be able to purchase the shares as if the valuation was at the cap. On the other hand, a lower valuation cap can result in less expensive investment as compared to new investors at the same level of ownership. As a result, if the valuation in the subsequent round is less than the cap, the conversion takes place at the current valuation.
2. Discounts
Discounts on future converted equity in SAFE means that the investors who hold SAFE note will be able to buy their shares in case of future financing at a discounted rate as compared to the value of shares. For example, if the SAFE note holder is offered a 10% discount by the company and the company achieves a valuation of $10 million at $ 10 per share for new investors, then the SAFE holders will be able to buy their shares at $9 per share due to 10% discount. The range of these discounts is usually between 10% to 30 %.
The company needs to be careful in negotiating the discount rates because higher discount rates will result in less equity for founders and future investors and more ownership for safe investors which can hinder the company’s ability to raise reasonable funding in the next funding rounds.
Agreeing to SAFE notes rewards investors for being allowed to potentially own more of a company and pay less for ownership than others who invest in the business later
3. Maturity Date:
The maturity date is an important element while differentiating SAFE and Convertible notes and presents an advantage for companies to choose SAFE over Convertible notes. Since SAFE notes are not debt, they don’t have any maturity date. However, convertible notes have a maturity date as it is a form of debt.
When the maturity date comes, the company has to either pay back the principal debt amount along with interest or convert the debt into equity. However, if the investors prefer to get their principal back, it can be a problem for the company if it is unable to pay back and can lead to bankruptcy. Sometimes, however, a SAFE might have a maturity date, however, if the company hasn’t received a post-money evaluation by the maturity date, the conversion of SAFE will take place at a pre-agreed valuation.
4. Pro-Rata Rights:
Also known as participation rights, pro-rata rights allow investors to maintain their percentage of ownership in case of future equity financing, by enabling investors to invest some extra funds.
5. Most-Favored Nation Provision:
This element of SAFE requires the company to notify the first SAFE about multiple SAFE notes, in case of multiple SAFE notes so that the first SAFE holder can ask for the same terms as the subsequent SAFEs in case they find them more favorable.
Types of SAFE Notes:
SAFE notes have the following types which can be chosen by the company while issuing SAFE note:
· A valuation cap, but no discount
· A discount, but no valuation cap
· A valuation cap and a discount
· No valuation cap and not discount.
Pros and Cons of using SAFE notes:
There are several advantages and disadvantages of using SAFE notes for seed funding as compared to other options.
Pros of using SAFE notes
Here, we will discuss some pros of using SAFE Notes as compared to convertible notes and priced financing rounds.
Priced rounds involve fundraising by selling a portion of the stock at a certain price. These involve the issuance of a new class of shares in the company, preferred shares.
1. Simplicity:
As they are usually less than five-page documents, they are easier to understand. Moreover, since they are not debt, they do not have complicated terms for maturity date and interest rate as compared to convertible notes.
2. Interest Rate and Maturity Date:
Convertible notes work as debt and hence, carry an interest rate usually ranging between 2%-8%. This interest is an additional expense for the company; hence, SAFE Notes can save these expenses as they don’t carry an interest, rather, they work as a warrant and not debt.
As convertible notes carry maturity date, the company has to either pay back the principal and interest or issue preferred stock, once the maturity date passes. However, since SAFE notes do not contain a maturity date, they are a safer option in case the company is not performing well.
3. Easy Documentation:
SAFE notes are relatively easier in terms of documentation as compared to priced rounds. A priced round requires an SEC filing which details the stock offering, including items like how many shares were offered for sale, at what price, and the identities of the purchaser or purchasing entity. However, there are no such filing requirements for SAFE notes.
4. Legal Fee:
As the startups are low on funds, they will have more advantage in unpriced rounds as compared to priced rounds. As there is less negotiation required and agreement points for documentation, legal fees for unpriced rounds are less as compared to priced rounds. Moreover, for priced financing rounds, the legal fee for investors is typically paid by the company.
5. Benefits of Discounts:
SAFE notes provide investors with an incentive to get a discount on the future preferred stock of the company as it grows. Henceforth, they can get more price benefits as compared to investing directly in preferred stock.
Series A round is one of the stages in the capital-raising process by a start-up. Similar to seed financing, series A financing is equity-based financing and it is the second stage of financing for start-ups.
Cons of using SAFE notes vs Priced financing rounds
1. Risk of conversion:
There is a risk that the company might never grow to the extent that its stock converts into equity. Henceforth, it is not certain for the investors that they will get ownership of the company’s stock.
2. Conversion point into Equity:
SAFE notes allow conversion into equity only into the next round of financing, i.e., into Series A or Friends and Family round. However, convertible notes allow for conversion within the same round of financing, i.e., with seed financing as well. Hence, in this case, convertible note allows for better control for the company as compared to the SAFE note.
3. Dividends:
Usually, dividends are the rewards for investors for investing in shares when a company is performing well. However, SAFE doesn’t provide dividends to the investors, the only reward that investors receive is the equity that they gain.
4. Risk of dilution:
SAFE Notes might not prove to be as safe due to the risk of dilution. If the investors agree to purchase a huge number of shares, at the time of conversion, the founders will have less ownership and control over the company and this can result in difficulty during Series A financing. This is because SAFE notes do not show the impact of dilution only until they are converted into equity, henceforth, the founders are unable to see the dilution impact on their cap table that can pose some complex risk.
5. Negotiating Valuation Cap:
There is a conflict of interest between investors and founders in the case of the valuation cap of both Convertible notes or SAFE notes. Investors would like to agree on a valuation cap as a way to gauge the company’s current value. They would like to be compensated for their early, high-risk investment when the company gets a good pre-money valuation. However, for founders, a valuation cap is a negotiating point that might not be very clear for them at the early start of the company.
Example of SAFE Notes:
Cash Investment: $100,000
Valuation Cap: Not applied
Discount Rate: 30%
Conversion Trigger: The founders of the company have been able to agree with the investor to negotiate on selling Series A Preferred Stock worth $1 million when the company receives a pre-money valuation of $10 million.
The fully-diluted outstanding capital stock of the company is 11 million shares including a 1 million share option pool. The new Series A Preferred share investor will be issued 11,00,110 shares at $0.909 per share. The preferred shares issued to the safe holder will depend on the 30% discount rate. The 30% discount rate applied to the Series A Preferred Share results in a price per share of $0.6363. As a result, the company will issue 1571586 shares to the safe holder at $0.6363 per share.
Pre-money valuation is important to determine the percentage of ownership investors claim after investment. It is the value attributed to the start-up before it raising any public funding or outside investment.
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