Differences Between a SAFE, Convertible Note, and Equity Financing
Whether you are an entrepreneur or an angel investor, the topic of convertible note vs. equity impacts you. For the most part, startups favor convertible notes and angels prefer equity, but which one is the right choice for your startup?
Here, we review the benefits of each.
Convertible Note or Convertible Debt
Convertible debt is most commonly used as a bridge loan between two rounds of financing. For example, if you raised $1,000,000 in series A funding and you were going to raise $5,000,000 in a series B round, you might use a bridge loan if you needed $250,000 until the funding was completed. However, convertible debt has recently become a popular seed round financing instrument.
Here is a basic overview of how convertible notes work:
An angel investor invests $200,000 in a startup as a convertible note.
The terms of the note are a 20% discount and automatic conversion after a qualified financing of $1,000,000.
When the next round of funding occurs at $2,000,000, the investor's note will automatically convert to equity.
In this scenario, let’s assume the shares were priced at $1.00. Since there is a 20% discount, the investor can use that $200,000 investment to purchase shares at the discount rate of $.80 each, instead of the $1.00 price that other participants in the current funding round will have to pay. That gives the initial investor 250,000 shares for the price of 200,000, which is a 25% return — not bad.
Caps can also be added to convertible debt. A cap sets a limit for how much the startup can raise before your shares stop getting diluted. It doesn’t value the convertible note, but it sets an upper limit. So in the example above, if the pre-money cap was $5,000,000, you would still get a discount of 20% up to that amount. If the startup raised at a valuation over $5,000,000, then the discount would increase to offset the additional dilution that was occurring. When you add a cap, the math gets a little trickier, as it can change with different funding scenarios.
While a convertible note might be a little confusing to calculate, equity is a breeze. The startup is assigned a pre-money valuation and a share price is determined. When you invest, you know exactly what the terms are and how many shares you will own in that round.
Here's how it works:
The startup has a pre-money valuation of $1,000,000 with 1,000,000 shares outstanding. This puts the share price at $1 per share.
An angel investor makes an investment of $200,000 and receives 200,000 shares.
The post-money valuation is $1,200,000 and the new investor owns 16.6% of the company.
Why Convertible Debt?
If equity is so much easier to understand, why are convertible notes becoming more common in the startup community? Here are four reasons why:
- Valuation: Determining the valuation of a startup is hard, especially if the startup is pre-revenue and only in the idea phase. How do you put a value on the potential of the team/idea? It is easier for a startup to put off that question until they have some traction and social proof. Convertible notes are attractive for a startup because it delays this issue. While adding a cap essentially prices the round, it does leave a range of options, so it is more attractive to the startup.
- Cost: Convertible note term sheets are less expensive than term sheets for equity, although with new standard term sheets that cost difference is starting to diminish. Sometimes it doesn’t make sense to pay the additional legal costs for closing the equity round if the funding increase is less than $250,000.
- Speed: The equity valuation conversation can take weeks of negotiating before terms are agreed upon. With debt, the terms are simple, easier to negotiate, and you can close on them pretty quickly.
- Control: When a startup raises debt, the founders retain the majority of the voting stock in the company. That means when it comes time to make a decision that requires a vote, you will be in a better position to execute your plan. You might get a broad seed request with a larger debt investment, but typically in a seed stage offering, you won’t have to worry about that.
Every situation calls for a different type of financing structure. It is important that each benefit is weighed to see what is right for the startup and for the investor. As a startup, you want to give your early investors good terms because they are helping you accomplish your goals. As an investor, you want to make it as easy as can be for the startup because they need to be focusing on building the business and not revising terms for an offering.
Now, the simple agreement for future equity (SAFE) is also a common equity funding document used by startups and investors in seed-stage funding deals. The SAFE was created by the Y Combinator, a famous tech accelerator located in Silicon Valley, California. The SAFE creates an alternative to traditional seed-stage financing arrangements employing convertible notes or preferred shares.
How does a SAFE Work?
The SAFE grants investors the right to purchase equity in the company at a future date. Generally, the investors will seek to purchase preferred stock shares during a future funding round lead by other investors, upon acquisition of the company, or upon the company filing for an initial public offering. This approach allows the company and investors to delay the negotiation of company valuation and terms of investment (liquidation preferences, anti-dilution measures, etc.) until the realization of a later equity funding event.
The specific terms of the SAFE will vary based upon the two most important characteristics – the SAFE “valuation cap” and the SAFE “discount rate.” The valuation cap sets a maximum amount that the investor will pay for preferred shares in a future equity round – regardless of the total valuation. The discount rate provides a discount on the purchase price for later investors in an equity financing round.
If the company dissolves before a future equity funding event, the SAFE investor receives priority in the return of her investment above other shareholders. Generally, the SAFE investor has a 1x liquidation preference. The SAFE may also allow for conversion rights. That is, in the event of an acquisition or IPO, the SAFE investor can convert her SAFE interest into common shares (rather than a future class of preferred shares). The valuation for the common shares are generally based on the valuation cap applicable to the future equity funding event.
How does the convertible note work?
A convertible note provides an interest-bearing loan to the company. The investor will either receive a balloon payment on the note at a specified date (maturity date), usually one year from date of the loan, or be allowed to convert the note into preferred shares during a future equity funding event. The convertible note does not attribute a valuation to the company at the time of signing the convertible note. The future conversion of the note into preferred shares will be based on the valuation in a future financing event. The convertible note will also have a valuation cap that limits the amount that the convertible note holder must pay for the preferred shares. Also, the notes generally allow for a discount on the preferred share purchase price paid by the future investors. Read more about convertible notes in equity financings.
Which is better?
The convertible note and the SAFE work very similarly. The difference is that the convertible note is a debt instrument (or loan) that converts to equity. The SAFE simply provides the right to purchase equity at a capped price (possibly with a discount) during a future equity funding event. What are the benefits and how do they compare?
Interest Rate – The convertible note provides an interest rate to the investor. In reality, investors do not invest in companies to earn an interest rate on loaned funds. They expect the company to perform well and offer a return at a future sale of the ownership interest. The SAFE has no accruing interest or maturity date.
Deferring Valuation – Accurately valuing an early-stage company is extremely difficult – if not impossible. The convertible note and the SAFE allow the investors to defer valuation of the company until a later date when proven valuation methods are useful.
Caps and Discounts – Both convertible notes and SAFEs typically employ caps on the potential valuation of the company at a future period. This will ensure that the investor get a great deal on the purchase of equity if the company valuation exceeds the capped amount. Further, the companies generally allow for discounts off the future equity price. This will provide a deal to investors in purchasing the equity, even if the value of the company is below the cap.
Deferred Equity Characteristics – As part of an equity purchase, the parties will negotiate the terms of the preferred stock. Sometimes the investors will negotiate dozens of terms. These terms can be difficult to effectively negotiate when the valuation is uncertain and operational aspects of the company are yet to be determined. The SAFE always for deferral of negotiation of preferred share rights until a future equity funding event. At that time, the future investors (who are often more experienced in such matters) will undertake the task of negotiating the equity terms. The SAFE and convertible note generally come with conversion rights where the investor can convert the shares to common shares or receive a return on their investment in the event the company is acquired before a future equity investment round.
Control of Financing Amounts – Using a convertible note and a SAFE allows greater control over how much money a company seeks at any time. Given the difficulty of negotiating a preferred equity financing, companies would generally sell 15-30% of equity in a seed round. This would cause extensive dilution of the owners’ interests. The simplicity and ease of use of the SAFE allows the investors to seek funding with greater frequency and when is convenient.
Low Costs – Hiring counsel to assist with an equity funding event can be very costly. This is particularly true when the funding requires extensive negotiation between an investor’s attorney and the company’s attorney. Using a convertible note or SAFE is far cheaper, with the SAFE being the cheapest. There is very little negotiation, which dramatically reduced the legal fees associated with the funding event.
Lending Laws – Some states place restrictions, such as licensing requirements, on lenders. A convertible note is a form of debt that may be subject to state regulations. The SAFE is an option to purchase future equity. It is generally exempt from state leading regulations.