SAFE Vs. Convertible Notes: What Startups Founders & Stakeholders Should Know
The startup world is full of complex financial concepts, and it can often be challenging to keep track of all the details.
In particular, there is a fierce debate going on right now about the relative merits of two popular funding models: SAFE and convertible notes. SAFE stands for “Simple Agreement for Future Equity,” while convertible notes are a type of debt that can be converted into equity later.
Many startups, founders, and stakeholders are trying to determine which model best suits their situation. To help shed some light on this issue, let’s look at what each model entails, its pros, and cons, and how it may affect you as an entrepreneur.
Whether you’re just starting or are looking for some guidance on your current funding situation, understanding the critical differences between SAFE and convertible notes will help you make more informed decisions about your business’s future.
What is a SAFE Note?
A SAFE note is an investment vehicle that provides entrepreneurs with a way to raise capital from investors without giving up equity in their company. Instead of selling shares of stock, the entrepreneur sells the investor a promise to pay back the investment plus interest, like a bond.
The main difference is that the repayment is contingent on the company’s success; if the company fails, the investor will not get their money back.
Y Combinator first popularized SAFE notes back in 2013 and since, it has become increasingly popular for startups to raise money without giving up equity in recent years.
While SAFE notes carry some risk for investors, they can also be a desirable proposition if the company is successful. For entrepreneurs, SAFE notes provide a way to raise capital without giving up any company control. For investors, SAFE notes offer an opportunity to invest in high-growth startups without worrying about diluted ownership or complex voting rights.
How SAFE Notes Benefit Investors and Founders
SAFE Notes are an asset to both investors and founders. For investors, SAFE Notes offer several key benefits including providing greater flexibility when it comes to investment terms and can be customized to suit the needs of individual funds. Also, because SAFE notes are not debt-based, investors do not need to worry about being prematurely repaid and losing out on potential returns.
For founders specifically, there are several benefits to SAFE notes. They allow founders to remain focused on their long-term vision while granting them immediate access to capital with minimal restrictions or legal expenses. SAFE notes offer attractive terms for founders, with no interest payments required and only limited penalties in the case of early repayment or default.
Overall, SAFE Notes offers tremendous benefits for both investors and founders alike. Whether you’re looking to invest in startups or start your own company from scratch, SAFE Notes are a valuable tool to consider.
Key Elements in a SAFE Note
There are several key elements involved in SAFE notes, each one playing an essential role in the overall process. These elements include standardization, analysis, fairness, and education.
For starters, standardization refers to the idea that all SAFE notes use a standard set of criteria to determine whether they are safe or unsafe. This allows lenders and investors to easily exchange information about the safety of different loans, enabling them to make quick and informed decisions about their investments.
Next, analysis is a crucial component of SAFE notes. By performing thorough analyses on each loan prior to purchasing it, lenders and investors can assess its level of risk and decide whether it is a sound investment. This not only helps to protect their investments but also ensures that borrowers receive fair treatment when dealing with financial institutions.
Lenders and borrowers benefit from the element of education in SAFE notes. Educating both groups about the transparent lending framework helps pave the way for more even-handed transactions and fosters confidence between all parties involved in the process. Therefore, by carefully balancing these key elements within SAFE note programs, we can create safer lending practices that benefit everyone involved.
Drawbacks and Considerations When Using SAFEs
While the benefits of SAFE notes can be significant, there are also drawbacks to consider when utilizing them.
First and foremost, SAFE notes are generally only accepted by small investors and startups rather than large institutions, so if you need to deposit or withdraw funds quickly, they may not be the most efficient option.
Estimating Ownership Dilution from SAFEs
To estimate how much ownership equity may be lost through a SAFE, it is essential to understand how many shares are technically issued under a SAFE and how they are valued upon conversion.
On the one hand, if only founder shares are issued under a SAFE and those shares have an Initial Conversion Price at or above the company’s valuation cap, there will likely be little (if any) ownership dilution.
Also, if additional investor shares are issued under a SAFE with each conversion and those shares have an initial conversion price below the market rate (especially compared with regular investor rounds), significant ownership dilution may occur. Because SAFE notes allow investors to keep their equity even if they choose not to put in more capital later, it can sometimes be challenging to determine how much ownership share each investor holds.
Ultimately, it is impossible to know exactly how much ownership dilution may result from using a SAFE until all options are explored. But by understanding key factors such as valuation caps and initial conversion prices, entrepreneurs can make informed decisions about their funding options and minimize the risk of ownership dilution.
How Does a Company’s Market Valuation Affect the SAFE Agreement?
A valuation cap is the maximum valuation that a startup can receive during a SAFE agreement. The valuation cap is typically set at the pre-money valuation of the company. That said, the valuation cap will also increase if the company’s valuation increases during the SAFE agreement. However, if the company’s valuation decreases, the valuation cap will remain the same.
As a result, there is much debate about whether market valuation can impact the SAFE agreement. It may be possible that the current market valuation of a company can affect the terms and conditions of the SAFE agreement.
For example, if the company’s market valuation has recently gone up significantly, it might make sense for investors to require more equity in exchange for their funding. Alternatively, if the market valuation has decreased, it makes sense to offer investors fewer shares as compensation to minimize losses.
Some experts believe that market valuation should have no bearing on the SAFE agreement because this type of contract protects investors against future losses rather than current gains or losses in share value. Alternatively, others believe that tying an investor’s compensation to the company’s valuation could lead to biased decisions about valuations and stem from conflicts of interest.
All in all, there is no clear answer regarding whether market valuation should impact how a SAFE agreement is structured and negotiated. However, it is an important question that deserves careful consideration by all stakeholders involved in this type of contract.
Other things to consider
Discounts, pro-rata rights, warrants, and OID are essential considerations when discussing SAFE notes for startups and investors. These terms refer to various equity-like agreements that early-stage companies often use.
A discounted price on the note typically represents an amount of money deducted from the initial sale price of a company’s shares to align better the interests of the company with those of its investors.
Similarly, a pro rata right refers to an investor’s ability to maintain their percentage holdings in the company upon subsequent rounds of investment or liquidation.
A warrant allows an investor to purchase stock at a specific price during either future rounds or the initial offering stage of a company’s life cycle.
OID (Original issue discount) is a number that specifies the interest rate charged if an investment is made at an earlier stage than the current market prices indicate.
Having a general understanding of these terms is crucial because they often dictate the control and ownership an investor will have in a company. Let’s say a startup is looking to raise money from strategic investors who can provide valuable resources and connections. In that case, they may be more willing to accept a lower valuation in exchange for warrants or pro rata rights. Alternatively, if a startup is looking for general funding with no strings attached, they may opt for a SAFE note with no discount or OID.
It is the most helpful to understand all the options available and make the best decision for the company’s particular needs.
SAFE vs. Convertible Notes: How to Choose?
Whether to raise money for your startup through SAFE notes or convertible notes can be a tough decision. Both have their pros and cons, and there is no one-size-fits-all answer. However, there are a few key differences between the two that you should keep in mind when making your choice.
What are Convertible Notes?
Convertible notes are a type of investment that can be used by entrepreneurs looking to obtain funding from investors. Essentially, convertible notes function like loans, but with one significant difference: rather than being repaid with regular interest payments, investors can eventually convert convertible notes into shares of the company once it goes public or is acquired.
In other words, rather than money being returned directly to the investor, the investor can ultimately receive a portion of the equity in the company in return for their initial investment. This makes convertible notes an attractive option for entrepreneurs looking to raise capital without giving up a large share of their company upfront.
Additionally, convertible notes tend to have lower interest rates and timelines than traditional loans, making them appealing to investors. That said, convertible notes are an innovative way for both entrepreneurs and investors to support and grow profitable businesses while minimizing some of the risks typically associated with investing in startups.
Why are Convertible Notes Used?
Both investors and startups use convertible notes for several reasons. For investors, convertible notes offer the potential for a higher return on investment than traditional equity investments. They also provide flexibility regarding when the investment is converted to equity, which can help manage risk.
For startups, convertible notes provide access to capital without giving up equity in the company. This can be especially valuable in the early stages of a company’s development when its value is more uncertain.
In addition, convertible notes can help preserve working capital, as they do not need to be paid back until the company raises additional funding. As a result, convertible notes offer many benefits for investors and startups alike.
Primary Benefits of Convertible Notes
Convertible notes are a popular financing tool for startups and there are several benefits to using convertible notes such as:
1. Convertible notes can help companies raise money quickly by simplifying the funding process.
2. They can provide flexibility in how the money is used. For example, a company may use the money to fund research and development or hire new employees.
3. Convertible notes can help companies attract investment from many investors, including venture capitalists and angel investors.
4. They can give startups time to prove themselves before giving up equity.
5. Convertible notes can protect companies from dilution if they do not perform well.
Disadvantages of Convertible Notes
There are several disadvantages to convertible notes, the most significant of which is the lack of protection for early investors. When these investors buy into a company at its earliest stages, they typically do so at a steep discount to compensate for the high risk of investing in a nascent business. Also, there are no guaranteed returns or other benefits like voting rights, dividend payments, or asset appreciation.
Another disadvantage of convertible notes is that they can be challenging to structure and scale up as the company grows. Unlike equity funding rounds, which assign financial stakes and voting powers based on individual ownership percentages, convertible notes are usually set up with a single funding amount from start to finish.
As the company grows and raises investment capital, this standardized approach can result in an increasingly diluted stake for existing investors, making it more difficult for founders to move their business forward and foster growth at crucial decision-making moments.
So, while convertible notes may seem like an appealing option in terms of initial investment cost and simplicity of arrangement, they ultimately leave many crucial decisions about running a company in the hands of external stakeholders.
Conditions for Convertible Notes
There are a few key things to keep in mind when it comes to convertible note terms, whether you’re investing or being invested in.
The key terms to look out for are the conversion price and the discount rate. The conversion price is the price per share at which the debt converts to equity, while the discount rate is the percentage by which the conversion price is lower than the price per share of the subsequent equity financing round.
In other words, if a company raises $1 million at a 20% discount, that means an investor can convert their debt into equity at a 20% discount as well.
As for interest rates, these are typically set by the market. These rates can vary depending on the stage of the company. However, it’s not uncommon for companies to offer a below-market rate to entice investors.
Whether investing or being invested, it’s essential to understand the key terms of a convertible note to make informed decisions about your investment.
When Do Convertible Notes Mature?
A convertible note is a short-term loan that converts into equity in a company. The conversion typically happens when the company raises more money, such as through a new round of funding. The loan terms, including the maturity dates, are negotiated between the borrower and the lender.
The maturity date is when the company must repay the loan. If the loan is not repaid by the maturity date, the lender may take legal action to collect the debt. Convertible notes typically have a maturity date of 12 months to 36 months, although shorter or longer terms are also possible.
While convertible notes can be an attractive option for companies seeking funding, they can also be appealing to investors because they offer the potential for a higher return than other types of investments.
Sum it up
So, what’s the verdict? Are convertible notes or SAFE notes a better form of investment for startups? As with many things in the business world, the answer is that it depends.
Convertible notes and SAFE notes both have their pros and cons, and the best choice for a particular startup will depend on the individual circumstances. However, both forms of investment can benefit startups, founders, and stakeholders interested in this form of financing.
So, if you’re considering raising capital for your startup, be sure to explore all your options to find the best fit for your company.
At M Accelerator we help businesses figure out the best strategy for funding and investment opportunities. Most founders believe that raising as much as possible is the solution to most problems for a startup. Often, though, economic implications of timing, equity, and investment journey, are not even considered.
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