Convertible Notes and SAFEs: A Deep Dive into Early-Stage Investment Instruments

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Convertible notes and Simple Agreements for Future Equity (SAFEs) are two prominent financial instruments employed during early-stage fundraising. While they share a common goal – to defer the valuation of a startup to a later date – their structure, terms, and potential impact on the company and its investors differ significantly. This article dissects the mechanics, pros, and cons of each, enabling founders and investors to make informed decisions.

What are Convertible Notes?

A convertible note is a form of short-term debt that converts into equity during a future funding round. The note specifies a maturity date, an interest rate, and a conversion mechanism.

The conversion usually occurs at a discount to the price per share in the next financing round, rewarding early investors for taking on more risk. If the startup fails to raise additional funding before the note matures, the investor can either extend the note’s term or demand repayment.

What are SAFEs?

SAFEs, introduced by Y Combinator in 2013, offer a simpler alternative to convertible notes. Like convertible notes, SAFEs are instruments that convert into equity during a future funding round, but with some key differences: SAFEs are not debt, and thus they do not accrue interest and do not have a maturity date.

SAFEs also typically convert at a discount to the price per share in the next financing round, similar to convertible notes.

Pros and Cons of Convertible Notes and SAFEs

Understanding the advantages and drawbacks of each instrument can help both founders and investors make a decision that aligns with their goals and risk tolerance.

Convertible Notes:

Pros:

  1. Established Precedent: Convertible notes have been around for a long time and are widely understood by the investment community.
  2. Interest Accrual: The interest component provides additional value to the investor, which can be converted into more shares during conversion.

Cons:

  1. Debt Obligations: If the company fails to raise another round before the note matures, it might face a significant debt obligation.
  2. Complexity: Convertible notes’ terms (interest rate, maturity date, conversion discount rate, cap) can make them more complex to negotiate and manage.

SAFEs:

Pros:

  1. Simplicity: SAFEs are simpler than convertible notes, with fewer terms to negotiate.
  2. No Debt Obligations: As SAFEs are not debt, there’s no risk of the company being burdened with a debt obligation if it fails to raise more funding.

Cons:

  1. Potentially Higher Dilution: Without a valuation cap, SAFEs can lead to more dilution for founders in a high-valuation scenario.
  2. Less Familiar: As a newer instrument, SAFEs may not be as well-understood by some investors, particularly outside of the U.S.

Making the Choice: Convertible Notes vs SAFEs

There’s no one-size-fits-all answer as to whether convertible notes or SAFEs are the better choice for a particular startup or investor. The decision will depend on factors such as the company’s financial situation, its projected growth trajectory, the risk tolerance of the founders and investors, and the funding environment.

While convertible notes might be better suited for situations where the time to the next equity round is relatively short, SAFEs can be attractive for startups that want to avoid debt obligations and raise money quickly and simply.

It’s crucial to understand the mechanics of these instruments, their implications, and the terms being negotiated. Contact us to learn more!