Raising capital for startups can be challenging. Every startup founder is sure their company will be the next unicorn. But lenders are understandably skeptical. After all, statistics prove that more than two-thirds of startups never deliver a positive return to investors.
Assuming you have the right combination of “horses” (opportunities) and “jockeys” (business leaders), all you need is funding to move your venture in the right direction and race past the competition.
Analogies aside, you need some cash for your early-stage startup. So, what are your options? Many of today’s business founders are choosing between SAFEs and Convertible Notes until they can grow the business enough to warrant a priced round. Here is what you need to know about these two startup fundraising options, including their main features and differences.
SAFEs for Startup Fundraising
SAFE is an acronym for Simple Agreement for Future Equity. The term was developed by Y Combinator in 2013 as a means for entrepreneurs to secure cash immediately. In exchange, investors get ownership of a business at some future date.
SAFE agreements are known for being brief, only about 5-10 pages long. The idea is to connect a startup business with an investor who is willing to accept a future equity stake in exchange for an immediate investment.
How SAFEs Work
SAFEs allow investors to buy shares in a company in a future round at an undetermined price. Startups often use this option at the earliest stages of fundraising. Because the company doesn’t have any determinable value at this point, the founders are able to raise money without having to set a specific share price, which might end up being too high or too low.
The investor is purchasing the right to convert their investment into a future equity stake in the company once a pre-determined event is triggered. That event is usually a first priced equity round. It might also be something like the sale of the company.
The investor’s equity stake will depend on the amount invested as well as the share price at the next funding round or a liquidation event. But there is also never a guarantee that the triggering event in the agreement will happen.
Essential Elements of a SAFE
Not all SAFEs will convert exactly alike. Here are the primary elements that can impact how your startup financing using SAFE will work:
Many SAFE investments have a discount ranging from 10% to 30% on future equity. For example, if the next equity funding round is the triggering conversion event, the SAFE discount is 20%, and the share price is set at $10, the investor will be able to buy the shares at the discounted rate of $8. The discount rate means the investor is able to purchase the shares at a lower cost than the current value. So, 100 shares would cost the investor $800 instead of $1,000.
- Valuation Caps
The valuation cap is the maximum price your investor will pay for their shares, regardless of what the subsequent equity round pricing is set at.
- Pro-rata Rights
If pro-rata rights are negotiated as part of the SAFE, the investor has the option to invest additional money in the company when the triggering event occurs to maintain their percentage of equity in the business.
- Most-favored Nation Terms
If an investor is offered more than one SAFE option, the startup will have to inform existing SAFE investors about subsequent agreements. If the new SAFE agreements have better terms, existing SAFE investors will have the option to request the same terms.
Convertible Notes for Startup Financing
Convertible notes, also called “C-Notes,” are simple in concept. But there are some subtle details in the structure of these options that make understanding the basics critical. The general idea behind this type of financing is that the investor will provide startup funds in exchange for some dollar value in equity in the company at a later date. So, instead of giving the investor a percentage stake in the company right away, the startup signs a promise that converts to equity with agreed-upon terms.
How Convertible Notes Work
Convertible notes are considered to be debt instruments with the general understanding that the debt won’t be paid in cash. But it might be. What? As the startup owner, you negotiate terms with the investor in which the note will be converted from debt to equity either after a specified period (maturity date) or once the startup reaches an agreed-upon valuation. But the noteholders may have the right to ask for repayment of the debt if the maturity date is reached before the startup is able to raise an additional qualified financing round.
SAFEs vs. Convertible Notes for Startup Fundraising - What’s the Difference?
Both SAFEs and convertible notes offer startups ready access to funding and are intended to be converted to equity. But there are some significant differences between the two strategies if you’re weighing your options for startup fundraising.
Valuation Caps and Dilution
You, as the startup founder, will need to negotiate the valuation cap with either a SAFE or convertible note. It’s vital that you understand how this figure impacts your business. When you secure startup financing with equity, you are exchanging a portion of your ownership. The valuation cap is the maximum valuation used to calculate the company share price at which your investor’s funds convert to equity.
At your next round of equity financing, assuming your company is valued much higher than the valuation cap on your notes, you may end up issuing more shares of equity than you had planned. The valuation cap is one of the most attractive aspects of both SAFEs and convertible notes. But it’s vital to consider how much you might end up diluting your ownership stake when you negotiate this figure.
SAFEs aren’t loans, so they don’t have interest rates attached to them. But convertible notes are considered debt instruments, so they do. The interest rate attached to C-notes is usually in the range of 2% to 8%. When the triggering event takes place, the interest and principal on a convertible note will convert to equity.
SAFEs are not debt instruments, so they do not have maturity dates. Convertible notes do have maturity dates, which may create issues for a startup once that date arrives. When a C-Note hits its maturity date, the startup has two options:
Convert the debt to equity as agreed, or
Pay back the principal plus interest.
If the startup isn’t performing as planned, the second option can be challenging. In some cases, it can even lead to bankruptcy.
Both SAFEs and convertible notes have provisions that address how investors will be paid when there is a change in control of the startup, such as an IPO or a buyout, before the conversion takes place. With SAFEs, the investor can choose to convert their note to equity at 1X payout or the valuation cap. The procedure isn’t as standard with convertible notes, where payout options will be more varied. However, 2X payouts are common with these agreements.
SAFEs offer more fundraising flexibility. These are generally stand-alone agreements between startups and individual investors. These types of agreements allow startups to reward early investors with more favorable terms, like valuation caps. SAFEs can be issued on a rolling basis with changing terms as investor interest increases. This ability allows companies to test the waters and adjust the terms to meet market conditions.
Convertible notes are structurally more complex than SAFEs and more difficult to issue on a rolling basis. This is because C-notes are considered loans with interest and maturity dates, so you’d need to track debt instruments with multiple terms. Convertible notes are often structured as a single agreement that covers all C-notes issues. The agreement, referred to as the Note Purchasing Agreement (NPA), lists all the terms. Each investor will then have their own promissory note that details the amount and date of their individual investment.
Administrative Fees and Services
There is debate about whether a SAFE would require a fair (409a) valuation to formalize your company’s common stock value. If it did, you would be exposed to potential administrative and professional service fees to produce that valuation.
Pros and Cons of SAFEs
If you’re still on the fence about using SAFEs vs. convertible notes for your startup fundraising, it might help to examine the advantages and disadvantages of each. Here is a breakdown of the pros and cons of using SAFEs.
Pros of SAFEs
Since they are usually only about five-page documents, SAFEs are generally pretty simple to understand. And, since they aren’t considered debt instruments, they don’t have complicated terms like interest rates and maturity dates. Instead, there are trigger events.
- Easy Documentation
In terms of documentation, you can’t get a much simpler funding option than a SAFE. For example, a priced round requires a complex SEC filing that includes a lot of details. SAFE notes have no such requirements.
As your company grows, SAFE notes give investors an incentive to provide funding in exchange for a discounted future stake in the company. These discounts can prompt investors to fund SAFEs instead of waiting around for your company to issue stock at full price.
- Lower Costs
Startups are often low on operating cash. Why else would you be looking at seed funding options? Because SAFEs are simpler and require less negotiation, your legal fees and other costs associated with them are likely to be fairly low.
Cons of SAFEs
- Conversion Risk
When you fundraise with SAFEs, there is a risk that your company might never hit one of the trigger events and provide promised equity to its investors.
- No Dividends
Usually, well-performing companies provide dividends to investors.
SAFE notes don’t necessarily show the impact dilution has until they are converted to equity. If you don’t calculate this potential upfront, you might lose the controlling share of your business.
- Value Cap Negotiation
There is a potential conflict of interest between founders and investors concerning the valuation cap of SAFE notes. Founders may not be clear about the valuation cap when their business is so young, and investors want to negotiate a certain cap so that they are well-compensated for their high-risk investment.
Pros and Cons of Convertible Notes
As a founder, it’s your responsibility to calculate the risks and rewards of using a particular type of financing for your startup. Here are the pros and cons of using convertible notes.
Pros of Convertible Notes
- Efficient and Low Risk
Practically speaking, convertible notes are considered loans. So they are simpler than many equity deals. This is a lower risk for investors, who may be more willing to come to the table to fund your startup.
- Lower costs
Because convertible notes are technically a form of debt, there is no requirement to issue stock to investors, which saves the hassle of stock option grants, complex company valuations, and tax implications.
- Deferred Negotiation
With SAFEs, founders must try to figure out the value of the company to prevent dilution and set the right caps. Convertible notes allow the parties to defer these negotiations until a later date when a fair price can be determined.
Cons of Convertible Notes
- Lack of Control
Since no one knows how much a company is worth at the startup stage, it’s difficult to determine if the terms of a convertible note are fair or not. If the company doesn’t launch a financing round by the maturity date, it may be forced to repay the debt.
- Discourages Future Investors
There is the potential that additional investors might be discouraged from joining in if too much equity is being returned to early investors.
- Potential for Nonpayment
Startups can run into unforeseen financial straits. When founders are unable to raise additional capital, secured lenders are repaid first. There is also the potential for bankruptcy to avoid personal liability.
The Next Steps
Understanding your options for startup fundraising can put you on the pathway to success. First, outline your goals and then open up a conversation with your financial leadership and lenders to figure out the best strategy. There are advantages and disadvantages to fundraising using SAFEs and convertible notes, so the option you choose may be different from the company next door.
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About the Author
Gary Christianson is a senior executive with over 25 years’ accounting and finance experience with an emphasis on early-stage and venture-backed high growth technology start-ups. He has extensive experience as a member of management teams, collaborating with Board members and working directly with CEOs.