Startup Fundraising: SAFE v Convertible Note
When startups seek early-stage funding, they often turn to various financial instruments to secure capital from investors. Two popular options are a Simple Agreement for Future Equity (SAFE) and Convertible Notes. Each of these instruments has its own set of advantages and disadvantages, making it essential for entrepreneurs to understand their nuances before making a decision. In this blog post, we will compare SAFE and Convertible Notes to help startups make informed choices about their fundraising strategies.
- Definitions:
SAFE: A Simple Agreement for Future Equity (SAFE) is an investment contract between the investor and the startup. Unlike traditional equity, it does not involve issuing shares immediately. Instead, the investor provides funds to the startup in exchange for the right to obtain equity in the company at a later specified milestone, such as the next funding round or a liquidity event.
Convertible Note: A Convertible Note is a debt instrument that allows investors to lend money to a startup, which will be converted into equity at a future predetermined event, usually the next funding round. In essence, it is a loan that “converts” into equity instead of being repaid in cash.
- Interest and Valuation:
SAFE: SAFE instruments do not carry interest rates or a valuation cap, making it simpler in structure. However, this also means that the investor’s return depends entirely on the valuation of the next equity round. If the valuation increases significantly, the investor benefits, but if the valuation is low, the investor may receive a smaller equity stake than anticipated. However, in using a SAFE instrument, investors may be entitled to repayment before the company’s founders receive distributions.
Convertible Note: Convertible Notes typically come with an interest rate, which means the investor can earn interest on their loan before conversion. Additionally, Convertible Notes often have a valuation cap, which sets the maximum valuation at which the investment will convert into equity. This provides some downside protection for the investor and ensures they receive a minimum ownership stake even if the company’s valuation skyrockets.
- Conversion Triggers:
SAFE: Conversion of a SAFE into equity is usually triggered by specific events, such as a qualified financing round or a liquidity event. Until the trigger event occurs, the investor holds no ownership stake in the company, and there is no maturity date or repayment obligation.
Convertible Note: Convertible Notes have a maturity date, usually ranging from 1 to 2 years. If the conversion event doesn’t occur by the maturity date, the startup is obligated to repay the investor’s principal along with any accrued interest.
- Dilution Protection:
SAFE: SAFEs do not provide explicit anti-dilution protection for investors. As a result, if the company issues additional shares at a lower valuation than expected, existing SAFE holders’ ownership could be significantly diluted.
Convertible Note: Some Convertible Notes include anti-dilution provisions that protect investors from severe dilution. There are two main types of anti-dilution mechanisms: “full ratchet” and “weighted average.” These provisions adjust the conversion price if subsequent equity issuances occur at a lower valuation, ensuring investors’ ownership percentage remains fair.
- Documentation and Legal Costs:
SAFE: Compared to Convertible Notes, SAFEs are relatively straightforward and can be easier and cheaper to document. This simplicity can expedite the fundraising process for startups.
Convertible Note: Convertible Notes tend to be more complex, involving greater legal documentation and higher legal costs. However, the additional terms and protections they offer may outweigh the extra expense for some investors.
Conclusion:
Choosing between a SAFE and a Convertible Note depends on the specific needs and preferences of the startup and its potential investors. SAFEs are often favored for their simplicity and ease of use, while Convertible Notes provide more investor protections. Ultimately, startups should carefully consider their growth plans, valuation expectations, and the terms they are willing to offer to make the best decision for their fundraising journey. Consulting with legal and financial advisors is essential to ensure compliance with applicable laws and to structure the investment instrument that aligns best with the startup’s long-term goals.
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