In the early stages of a company raising capital may be essential, and two popular tools often used to structure early-stage venture capital styled investments are convertible notes and Simple Agreements for Future Equity (SAFEs). Both instruments can be used to raise seed funding before a formal valuation for the company is determined. While convertible notes and SAFEs are similar because they can both convert into equity interests of the company, there are key differences between the instruments that entrepreneurs and investors should understand. This article explains the key terms and highlights the differences between convertible notes and SAFEs. You should consider these points when deciding which option might be best suited to your fundraising or investment needs.
Key Terms Shared by Convertible Notes and SAFEs
Both convertible notes and SAFEs (collectively, “Convertible Instruments”) share the following features:
- Conversion Events:
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- Qualified Financing. Convertible Instruments convert into equity if a “conversion event” occurs, usually when the company raises its next priced round of equity investment that meets a “qualified financing threshold.” A qualified financing threshold is a dollar amount of aggregate investment that the company must raise to cause automatic conversion of the Convertible Instruments. Qualified financing thresholds ensure that the company raises a meaningful amount of money in order to qualify as a conversion event. Upon conversion, the holder of the Convertible Instrument typically receives either a discount (described below), conversion at a valuation cap price (described below), or whichever conversion price is more advantageous to the investors as between the discount and the valuation cap price.
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- Liquidity Event. Convertible Instruments may also have conversion events that include the company undergoing a change of control (i.e., greater than 50% ownership change), a sale of the business transaction, or an IPO. For conversion events such as change of control, sale or IPO, the Convertible Instruments would either automatically convert at the valuation cap price or be treated “as-converted” and repaid a pre-negotiated amount with a premium. It is not unusual to see premiums of 150% or more of return on investment if the Convertible Instrument were paid off as part of a change of control transaction or sale of the business.
- Discount: If the Convertible Instrument is converted and the “discount” is applied, then the holder of the Convertible Instrument would receive its equity shares at a discount as compared to the price per share paid by “new money” investors in the priced round. Customary discounts range from 10-25%. For instance, if the price per share for the company’s initial priced equity round was $1 per share and a 20% discount applied, the holders of the Convertible Instruments would receive their shares at $0.80 per share. If the Convertible Instrument includes a provision that the better of the discount and the valuation cap would apply, then the discount only applies if the priced equity round is raised at a valuation price that does not exceed the valuation cap.
- Valuation Cap: If the Convertible Instrument is converted and the “valuation cap” is applied, then the holder of the Convertible Instrument would receive its equity shares at the valuation cap price, which is a predetermined maximum conversion price. This protects investors in the event the company achieves “hockey stick” growth metrics (i.e., the company’s value increases rapidly to a high valuation), by locking in today’s maximum price notwithstanding that the company raised its priced equity round at a valuation exceeding the valuation cap price. For instance, if a Convertible Instrument had a $10 million valuation cap, but the initial priced equity round is raised at a $20 million valuation, then the holder of the Convertible Instrument would receive twice as many shares as the investors investing directly in the priced-round (on a dollar-for-dollar basis). If the Convertible Instrument includes a provision that the better of the valuation cap and the discount would apply, then the valuation cap only applies if the priced equity round is raised at a valuation price that exceeds the valuation cap.
Key Differences Between Convertible Notes and SAFEs
- Interest Rate: Convertible notes accrue interest on the principal amount invested while outstanding. Customary interest rates for convertible notes range from 5% to 12% but can vary based upon current market conditions and the applicable federal minimum interest rate. Upon conversion of the note, the accrued interest is capitalized and added to the principal amount invested. SAFEs do not accrue interest, which is beneficial to the company to only be required to convert the principal amount invested to equity.
- Maturity Date: Convertible notes have a fixed maturity date, at which point the note must be repaid. While investors can demand repayment at maturity, if the company lacks the ability to repay, in the startup company context, the parties usually agree to extend the maturity date to give the company additional time to perform. Typical convertible note maturity dates range from 12-36 months. SAFEs do not have maturity dates, which benefits the company by providing more flexibility on timing for achieving a conversion event.
- Debt Obligation: A convertible note is a recognized debt instrument and gives investors the right to call an event of default if the note is not repaid at maturity. Investors also receive the benefit of common law lender’s rights, which includes priority treatment in a liquidation or dissolution prior to equity holders receiving any remaining proceeds. Holders of SAFEs are less secure than holders of convertible notes since SAFEs do not have an unconditional repayment obligation.
- Socialization. Since convertible notes are debt and have been around longer than SAFEs, it may be easier to explain a convertible note investment to “friends and family” investors, whereas SAFEs are more familiar to professional investors and VCs. SAFEs may require more time and effort to explain to retail investors.
Conclusion
Convertible Instruments serve as powerful tools for startups and investors to navigate early-stage fundraising needs and to efficiently raise pre-seed and seed rounds. While convertible notes offer investors the security of debt, SAFEs present a more company-friendly approach. Understanding the nuances of both instruments can help startups and investors choose the best financing method based on their circumstances.