In this blog, we will analyze the key differences between convertibles and SAFEs. When it comes to seed investment for startups, there are a wide range of options available for founders looking to raise the money they need to start making an impact and growing their businesses, while avoiding the worry of having to immediately pay back debt. This is particularly vital for SaaS environment and tech startups comprised of teams working around the clock to enhance their product and who often neglect vital administrative issues.
It is essential that entrepreneurs understand the investment options available to them.
It’s also safe to say that young entrepreneurs who find themselves in the midst of launching an exciting new startup face a huge range of challenges and busy schedules that don’t always allow them to investigate their options properly. Knowledge is certainly power, and it is essential that entrepreneurs understand the investment options available to them and get the expert financial advice to start raising funds. In this blog, we’re going to walk through the key features of Convertible Notes and SAFEs..
Convertible Notes: speed and ease often attract founders
A Convertible Note can best be described as an investment vehicle which is structured similarly to a loan. Therefore, the Convertible Note itself functions as a type of debt which can be converted into equity for the investor when a startup reaches an agreed milestone, hence the name “Convertible”, in contrast to those loans that require regular payback.
It is important to note that the debt automatically converts into shares of preferred stock. These notes often prove highly attractive for new startup CEOs who want to knuckle down and focus on growing their business with sufficient funding without the legal and administrative obstacles that often appear when trying to issue equity. This often involves huge administrative burden for even small equity investments; signing Convertible Notes seems like a better option for receiving quick investment. That said, Convertible Notes still involve a great deal more paperwork than SAFEs, which we’ll review in this article.
The benefits for investors are also crystal clear with Convertible Notes, considering that the potential for gaining lots of equity is high when dealing with a fast-growing startup.
However, it is important to bear in mind that Convertible Notes can present serious challenges which require careful consideration by founders. Budding entrepreneurs must remember that the funding achieved through convertible notes does not belong to the company and is essentially a debt until it converts.
SAFEs: debt-free convertible equity
SAFE stands for Simple Agreement for Future Equity and the concept itself was launched in the US by the Silicon Valley based accelerator Y Combinator with the ultimate goal of simplifying seed investment in a region thriving with innovation and tech-based startups.
SAFEs and Convertible Notes share some key similarities, principally in their role as drivers for helping new startups scale and grow in order to reach the milestones required for a Series A round. However, SAFEs differ greatly from Convertible Notes in the sense that they do not imply debt and simply buy investors a warrant to purchase stocks in a future priced round. This fact makes entering into a SAFE more attractive for investors and founders alike due to the lack of maturity date in comparison with Convertible Notes.
In reality, SAFE notes are a simple, streamlined 5-page document which was specifically designed to facilitate the process for founders, investors and their lawyers, as we’ve already seen.
SAFEs offer a straightforward option which doesn’t feature an interest rate or maturity rate.
It’s important to mention that SAFE notes are legally complex agreements in some jurisdictions, and it is important to check the local laws and options in the city or country where you’re launching your startup. If we take Spain as an example, local laws make SAFEs complex due to their interest-free nature which can trigger issues in terms of fiscal compliance.
Other key differences
Different points of conversion
Both Convertible Notes and SAFEs allow for conversion to equity. However, important differences exist in when this conversion can take place. Convertible Notes allow for conversion into a current round of stock or a future financing event, which typically only triggers when a qualifying transaction (as per the agreement entered into) takes place. On the other hand, SAFEs can convert when any amount of equity investment is raised, taking away an element of control from the founder.
Valuation Caps: the need for careful negotiation
Both Convertible Notes and SAFEs require the negotiation of a valuation cap. A valuation cap can be defined as the maximum valuation for calculating share price at which the investor’s money converts to equity.
Only Convertible Notes carry interest
Remember that only Convertible Notes carry interest, owing to the fact that SAFE notes are not loans and an investor’s ownership stake doesn’t change based on the length of time that the note has been held. On the other hand, Convertible Notes feature an interest rate of between 2-8%, which tends to come in at an average of 5%.
The last word
It’s vital to look at the unique features of each option when weighing up the next step in scaling your business. While there is no “right answer”, it is important to consult experts and understand the limitations in each jurisdiction. At The Startup CFO,we offer expert CFO services for startups drawing on our expertise and passion for growing your business and providing sound financial support and services every step of the way.