Comparing SAFE Notes and Convertible Notes
For startups seeking pre-seed or seed funding, options like SAFE notes and convertible notes are available. Choosing the right one depends on your venture’s circumstances. Understanding the differences between them is key.
Before we delve in, note that Diligent Equity offers a platform to model the impact of SAFE or convertible notes on your cap table, accessible for free.
Why Opt for Debt Funding Instead of Equity?
Startups often have low valuations initially. Selling shares at a significant markup post-incorporation can raise IRS concerns. Convertible notes were introduced to address this. They allow seed funding without immediate valuation, representing debt to avoid diluting ownership.
However, convertible notes can be complex. In 2013, SAFE notes were introduced to simplify this process. Unlike convertible notes, they involve convertible equity without debt or maturity dates.
Advantages of SAFE Notes
Convertible notes often entail lengthy negotiations. SAFE notes streamline and standardize seed funding. They’re downloadable from the Y Combinator website, usually spanning five pages with straightforward language and clauses. This simplifies negotiations, expediting funding agreements.
Differences in Equity Conversion
Both SAFE notes and convertible notes convert into equity. The key difference lies in conversion methods. SAFE notes have a specific conversion approach, converting into the next round of preferred stock issued during subsequent priced financing. Convertible notes offer varying conversion terms, triggered by specific events or agreements.
Valuation Caps and Dilution
Negotiating the valuation cap is crucial for both. It determines the share price at which investor funds convert into equity, impacting ownership dilution. Failure to consider this could lead to unexpectedly high dilution during subsequent rounds.
Interest Rates
Convertible notes involve interest rates, typically ranging from 2 to 8 percent. SAFE notes do not involve loans, hence no interest or maturity dates, ensuring investors’ ownership stakes remain unaffected.
Early Exits
Both address payouts in the event of a change in control. SAFE notes offer conversion at the valuation cap or a 1x payout, while convertible notes may offer variable payout terms, often including 2x payouts.
Maturity Dates in Convertible Notes
Convertible notes have maturity dates, usually 18 to 24 months after the closing date. If the next financing round doesn’t occur before the maturity date, options include repayment, conversion, or extension negotiation. SAFE notes eliminate this concern.
Structural Variances
SAFE notes provide flexibility in fundraising, often being stand-alone agreements issued to individual investors. Convertible notes are more complex to issue on a rolling basis, typically structured under a single legal agreement covering all financing.
Terms of Convertible Notes and SAFE Notes
Convertible note agreements include valuation caps, discount rates, interest rates, and maturity dates. SAFE notes offer various options, including valuation caps with or without discounts, Most Favored Nation (MFN) status, pro rata rights, or no caps or discounts.
Investor Preferences
Convertible notes are more familiar to most investors. SAFE notes offer more flexibility to founders and are considered more founder-friendly, with Silicon Valley investors often more accustomed to them.
Final Considerations
Choosing between a SAFE note and a convertible note depends on your company’s circumstances. Convertible notes delay valuation, allowing startups to focus on growth, while SAFE notes may still require a 409a valuation. SAFE notes offer simplified negotiation points and greater company control, but convertible notes may be preferred if attracting desired investors proves challenging.
As companies progress to Series A funding, valuation becomes necessary. Diligent Equity’s portfolio management software simplifies cap table management, ensuring a clear understanding of the impact of new term sheets on your business’s future
JLF Corporate Team
