When it comes to seed investment, founders have options. Typically they prefer low interest which is where SAFE comes in as a favorable alternative to convertible notes, but there's much more to the picture. Every entrepreneur should understand his or her options and make sure that they align with their long-term strategic fundraising plans.
Definition of Convertible Note
A convertible note is a type of debt that has the right to convert into equity when you hit an agreed upon milestone. FundersClub explains convertible notes as an investment vehicle that is structured similarly to a loan. However, as TechCrunch points out, this type of debt automatically converts into shares of preferred stock upon the closing of a Series A round of financing. The overall consensus about convertible notes is that they are known to be complex and therefore, finicky or glitchy.
Definition of SAFE as Seed Investment
SAFE is an acronym that stands for “simple agreement for future equity” and was created by the Silicon Valley accelerator Y Combinator as a new financial instrument to simplify seed investment. At its core, a SAFE is a warrant to purchase stock in a future priced round.
There are some similarities between SAFE and convertible notes investments. Both act as a viable way to help startups overcome their current big hurdle in growing or scaling to reach the milestones that warrant a Series A round. Also, both options carry a discount on the next round (or current round for convertible notes), so neither presents a clear advantage. With those in mind, looking at the differences will help an entrepreneur consider their pros and cons when determining their preferred seed investment terms.
How can startup founders decide between SAFE and convertible notes?
Let's take a look at seven key variables you should use to determine which type of investment will suit your startup’s needs and increase your access to funding.
1. SAFE Offers Simplicity by Minimizing Terms
As pointed out in the definition, convertible notes can be intricate and lengthy. On the flip side, a SAFE is a 5-page document that was created to streamline the seed investment process. Because simplicity is one of its primary goals, SAFE offers a straightforward option: SAFE doesn’t carry an interest rate and doesn’t have a maturity date.
2. Different Points of Conversion to Equity
Both SAFE and convertible notes allow for a conversion into equity. The difference here is that while a convertible note can allow for the conversion into the current round of stock or a future financing event, a SAFE only allows for a conversion into the next round of financing.
Also, convertible notes typically trigger only when a “qualifying transaction takes place” (more than a minimum amount dictated on the agreement) or when both parties agree on the conversion. The SAFE can convert when you raise any amount of equity investment. This is nice for simplicity, but it doesn’t give the control to the entrepreneur, which is why the convertible note looks to be the best choice for seed investment in this category.
Another thing to consider is that raising common stock doesn’t trigger a conversion for a SAFE investor, so entrepreneurs in need of some extra cash could do a "friends and family round" and avoid the conversion trigger if there is a need to bridge.
3. The Double-Edged Sword of the Valuation Cap
Depending on your negotiating skills and your company’s traction, you can get a SAFE or convertible note without a valuation cap. However, it's pretty tricky to do in this environment with either instrument, so there is no clear winner for seed investment in this category. There is, however, one word of caution raised by Andrew Krowne of Dolby Family Ventures in a July 2017 article for TechCrunch:
“We have observed that many founders don’t do the basic dilution math associated with what happens to their cap table (specifically their personal ownership stakes) when these notes actually convert into equity. By kicking the valuation can down the road, often multiple times, entrepreneurs end up owning less of their company’s equity than they thought they did. And when an equity round is inevitably priced, entrepreneurs don’t like the founder dilution numbers at all.”
The takeaway here is to make sure you understand that even if you have a discount, by foregoing a valuation cap at the seed stage, you could be diluting your shares and your future investors’ shares when you go to raise your Series A.
4. Slight Differences in Taking an Early Exit
If you're looking for an early exit, convertible notes and SAFE offer similar payout mechanism in the event of a change in control (acquisition/IPO) before a conversion can occur. The SAFE is written to give the investor the choice of a 1x payout or conversion into equity at the cap amount to participate in the buyout.
In our experience, there are typically 2x payout provisions in a convertible debt agreement, which can still be written into SAFE agreements. Both options have seed investment advantages in this category that ultimately depend on your preferences.
5. Low vs. Zero Interest Rate
SAFEs are not a debt instrument. Instead, they are defined as a warrant. That means they do not carry an interest rate. Convertible debt, however, can carry an interest rate ranging from a 2% - 8% (most falling around 5%).
Since most entrepreneurs don’t need another expense, a SAFE is the clear winner in this category. This is another example of how SAFE offers simplicity.
6. Maturity Date
Again, a SAFE is not a debt instrument and, therefore, it doesn’t have a maturity date. Convertible notes have a maturity date, and this can cause some issues when the maturity date comes to pass. Once you reach the date of maturity, an entrepreneur has two choices:
1) Pay back the principle plus interest (if the company has enough money to do that), or
2) Convert the debt into equity
Paying back your principal is difficult to negotiate if the company isn’t doing well, and investors want their money back. It could even trigger a bankruptcy. Since that is the last thing an entrepreneur would like to deal with, the obvious choice from this perspective is the SAFE.
7. Administration Fees and Services
It's debatable as to whether a SAFE would trigger the need for a fair (409a) valuation to formalize your company's common stock value. Avoiding this means you could potentially avoid paying for the professional services involved with getting a 409a valuation and keep putting your money toward building your killer product.
So What's the Best Option for Seed Investment?
We’ve broken down the similarities and differences between SAFE and convertible notes, but ultimately what might be a pro to one startup could be a con to another. There’s more to picture—especially at this point in your fundraising journey.
As you build out future plans, remember there’s no textbook way to scale your business, but there are anecdotal stories and wisdom that can help you understand and weigh your options at each crossroads (and remind you to stop and find joy in the process). The Startup Founder’s Guide to Fundraising is a compilation of both real-life fundraising stories startup founders and investor reporting requirements and expectations at each stage.
Looking for more information on SAFE Financing? Check out this link on Y Combinator's website.
Cover image courtesy of Tatters (via Flickr)