By
Alehar Team
November 22, 2023
•
7
min read
Exploring options for your firm?
Investors use a variety of instruments to provide capital to budding startups. Many are already familiar with equity financing, especially with frequent news of startups raising priced equity rounds. Investors also frequently use convertible notes and SAFEs, which have become popular ways to finance startups as they offer a blend of flexibility and simplicity that appeals to both founders and investors. These two financing methods have certain features that make them more attractive fundraising methods as compared to straight equity, particularly when fundraising for early stage startups.
Convertible notes and SAFEs have some key similarities but also differ fundamentally. Here, we provide a brief examination of each instrument and compare the two side-by-side, covering the standard features and pros and cons of each.
A convertible note is a form of debt financing or loan that allows the debt to be converted into equity later on. This conversion can occur once a triggering event happens, such as a qualified financing round or a financing round that exceeds a certain threshold, a change of control, or the maturity of the convertible note, among others. While the note is outstanding, it will accrue interest that will, depending on the circumstances, be converted into equity or repaid. Convertible notes also typically include covenants to adhere to and specify events that constitute default.
Common terms covered in convertible note agreements include the following:
Suppose there’s a startup called "TechNovate Inc." that decides to raise $500k in funds using convertible notes. They approach an investor named Jane, who welcomes the offer. They agree on the following terms:
A year later, TechnoVate Inc. has made significant progress and is ready for a Series A round. A venture capital firm is interested and agrees to invest $5 million for 20% equity, valuing the company post-money at $25 million (meaning a “pre-money valuation” of $20 million + the amount of funding $5 million leading to a “post-money valuation” of $25 million). For simplicity, we will assume that TechnoVate Inc. has 100,000 total shares after the Series A round and after Jane converts her note to equity. This means the venture capital firm is paying a share price of $250.
Now let’s say this Series A round exceeds the threshold for a qualified financing round, allowing Jane to convert her investment into equity. Without considering the interest, discount, or valuation cap, Jane's $500k would get her 0.4% of the company valued at $25 million. Since a year has already passed, Jane has earned $25k or 5% of her $500k in interest. So, Jane’s combined investment and interest total $525k, equating to 2.1% of the company.
The terms of the convertible note included a discount rate of 25%, so Jane’s $525k can convert into equity at $187.50 or 75% of the $250 being paid per share of the new investors. This means she could receive 2,800 shares or 2.8% of the company.
However, the $25 million valuation is way above the $3 million cap set in her note. So, the valuation cap comes into play. Instead of converting at the $25 million valuation, her note can convert as if the company were valued at $3 million. This means her $525,000 gets her 17.5% of the company.
In the end, the valuation cap offers Jane a better deal compared to the discount rate, so her convertible note converts at the cap, and she gets 17.5% equity of TechnoVate Inc. After the Series A round and conversion of Jane's note, the venture capital firm owns 20%, Jane owns 10%, and TechnoVate Inc.’s founders and early employees own the remaining 62.5%.
Note: For simplicity, this illustration does not incorporate an employee stock option pool.
A SAFE or Simple Agreement for Future Equity is a form of financing that allows investors to provide funding for the right to receive equity in the future. An investor will provide funding to the company and upon the occurrence of a triggering event, the investor will receive equity in the company in exchange for the money they invested. In contrast to convertible notes, SAFEs are not a type of debt but a type of warrant, which is a type of security that allows the holder to buy or sell shares at an agreed upon price. SAFEs also do not have interest rates and thus do not allow investors to earn interest from holding the security.
Going back to the TechnoVate Inc. example, suppose the company and Jane enter into a SAFE instead of a convertible note agreement but with similar terms:
Let’s say again that a venture capital firm agrees to invest $5 million for 20% equity at a post-money valuation of $25 million. Since Jane invested $500k through a SAFE instead of a convertible note, she has not earned any interest that can be converted to equity. So, Jane is only able to convert her $500k into equity.
Without considering the discount or valuation cap, Jane’s $500k investment is equivalent to 2% of the company. At a 25% discount, she would be able to convert her investment at $187.50 a share rather than $250, equating to 2,667 shares or 2.667% of the company. Since the SAFE includes a valuation cap of $3 million, Jane can convert her investment to 16.667% equity based on a valuation of $3 million instead of $25 million.
Since the valuation cap allows her to get a much better deal, Jane’s investment converts at the cap, resulting in Jane owning 16.667%, the venture capital firm owning 20%, and TechnoVate Inc.’s founders and early employees own the remaining 63.333%.
Note: For simplicity, this illustration does not incorporate an employee stock option pool.
Because convertible notes and SAFEs utilize a valuation cap and/or a discount rate, investors and founders can defer valuation, which may be contentious if the company is an early stage startup. Furthermore, these require less documentation and less legal and administrative work for both founders and investors.
Although the investors have to defer receiving equity for their investment, they may receive better terms when converting their convertible note or SAFE into equity at the maturity of the convertible note or during a triggering event such as a financing round or change of control.
Simplicity
SAFEs are typically easier to execute compared to convertible notes. This is because of the additional terms that convertible notes have, such as interest rate and covenants. Furthermore, there are no events of default under a SAFE that force the company to repay the investors their investment. These terms can result in extended negotiations and legal review and complicate the company’s cap table.
Flexibility
Convertible notes come with a maturity date, at which the loan amount and the corresponding accrued interest needs to be repaid if there hasn’t been a trigger event for conversion into equity. Startups need to factor both the maturity date and the covenants into their strategic decision making. Thus, convertible notes may require more oversight by both founders and investors after signing.
Investor Preference
Investors may have different preferences between convertible notes and SAFEs, depending on various factors. In certain markets, investors may prefer a convertible note over a SAFE due to familiarity, given that SAFEs were only introduced relatively recently in 2013. Investors’ preference may also depend on their risk tolerance, some preferring to ensure a timely return on their investment and others preferring to provide the company with the flexibility to pursue long term strategic plans.
It is important to note that relevant investment regulations may also differ across countries, potentially influencing the applicability of either instrument.
Convertible notes and SAFEs are practical fundraising options for early stage startups, providing more flexibility and simplicity than raising an equity round. Both of these securities allow startups to raise capital while also deferring valuation and the issuance of equity to investors. While similar in this aspect, they come with different sets of terms and thus have different implications for founders and investors.
At Alehar, we're deeply passionate about M&A and fundraising, equipping us with the expertise and extensive network needed to carry out transactions efficiently and represent the interests of our clients effectively. Our expertise is particularly valuable for transactions ranging from USD 3m to 200m, as we guide companies through every step of their M&A and fundraising journey (including both equity and debt transactions)