SAFE Note vs. Convertible Note: Key Differences and When to Use Them
Andreea Marinescu
Top Woman in business funding 2024| HealthTech and BioTech| Venture Builder |Emerging Manager| Start-up Accelerator| AI & Machine Learning | IT expert|Speaker| Tech Start-ups Mentor|Board of Advisor
Both SAFE (Simple Agreement for Future Equity) notes and Convertible Notes are widely used financial instruments for raising capital in early-stage startups. While they share similarities, their mechanics and implications for founders and investors differ.
1. What is a SAFE Note?
A SAFE (Simple Agreement for Future Equity) is a financing instrument that allows investors to provide capital to a startup in exchange for the right to acquire equity in the future, usually when the company raises its next priced funding round.
? Key Features of a SAFE Note:
? No Debt: It is not a loan, meaning there is no maturity date or interest. Investors don’t expect repayment in cash.
? Future Equity Agreement: The investor converts the SAFE into equity during a future funding round (at a valuation cap, a discount, or both).
? Simplicity: SAFE agreements are short and relatively straightforward compared to other investment instruments.
? Flexible Terms: No immediate need to set a company valuation.
2. What is a Convertible Note?
A Convertible Note is a hybrid instrument that starts as debt and converts into equity during a future funding round.
? Key Features of a Convertible Note:
? Debt Instrument: It is a loan, so it has an interest rate (typically 4–8%) and a maturity date (e.g., 12–24 months).
? Conversion to Equity: The principal amount plus accrued interest converts into equity at a discounted valuation during the next funding round.
? Potential Repayment: If no qualifying event occurs before the maturity date, the note may need to be repaid, which can strain the startup’s finances.
Key Differences Between SAFE Notes and Convertible Notes
Use Case Ideal for early-stage fundraising with no valuation pressure. Common for bridge rounds or when the startup needs a temporary loan with equity conversion later.
3. When to Use a SAFE Note
? Early-Stage Startups: SAFE notes are ideal when a startup is raising a pre-seed or seed round and wants a quick, flexible way to secure funding without negotiating valuation or dealing with debt.
? No Immediate Cash Flow: If the startup cannot afford potential debt repayment (as required by convertible notes), SAFE notes eliminate this risk.
? Friendly Terms: SAFE notes are founder-friendly, as they avoid the burden of interest and repayment obligations.
4. How SAFE Notes Help Entrepreneurs
? Simplicity: SAFE notes are short and standardized, reducing legal fees and time spent negotiating terms.
? No Debt Obligation: Founders don’t need to worry about paying back investors, even if the company struggles.
? Delays Valuation Discussions: SAFE notes allow founders to raise funds without having to agree on a valuation prematurely, which is beneficial if the startup’s value isn’t yet clear.
? Flexibility for Fundraising: SAFE notes can be structured with valuation caps, discounts, or both, giving founders flexibility to attract investors without extensive dilution.
5. How SAFE Notes Affect Fundraising and Future Rounds
While SAFE notes offer benefits, they can have implications for future rounds of investment:
Positive Effects:
? Streamlined Early-Stage Fundraising: SAFE notes allow startups to quickly raise capital and focus on building the business.
? Builds Momentum: By securing early funding, the startup can grow to the point where a priced equity round becomes feasible.
? Cap on Dilution: Founders can set a valuation cap to limit equity dilution, providing some protection in future rounds.
Potential Challenges:
1. Dilution Risk in Later Rounds:
? SAFE notes convert into equity during a future funding round, often at a discount or capped valuation. If too many SAFE notes are issued, founders may face unexpected dilution during the conversion.
? Example: If you raise multiple SAFE rounds with high valuation caps, the resulting equity dilution can impact ownership significantly during the Series A.
2. Stacking Discounts or Caps:
? If multiple SAFE agreements have different discounts or caps, it can create a complex equity structure when they convert, potentially deterring future investors.
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3. Future Investor Concerns:
? Institutional investors in Series A may dislike seeing many SAFE agreements, as they introduce uncertainty around equity distribution.
4. Lack of Valuation Pressure:
? While this is beneficial for founders early on, it may delay the process of understanding the company’s true value, which could complicate later negotiations.
When to Choose SAFE vs. Convertible Notes
? Choose SAFE Notes When:
? You want to avoid debt and its repayment obligations.
? You are raising an early-stage round and want a simple, quick fundraising process.
? You aim to raise funds without setting a fixed valuation too early.
? Choose Convertible Notes When:
? You need short-term funding with a possibility of repayment if a round doesn’t happen.
? You are raising a bridge round between funding stages.
? Investors prefer a more traditional instrument with debt features.
In conclusion, SAFE notes are generally more founder-friendly and flexible, making them a great option for early-stage startups looking to raise capital quickly and efficiently. However, founders should be mindful of overusing SAFE notes to avoid dilution and complexity in future funding rounds.
SAFE Note Calculation Example
Suppose an early-stage AI startup is raising a $1 million seed round from venture investors using SAFE notes with a $10 million valuation cap and 20% discount rate.
One of the investors, an angel investor, contributes $500k via a SAFE note — for which, the terms of the SAFE note are as follows:
Suppose twelve months later, or one-year after the seed funding, the startup raises a $6 million Series A round at a $20 million pre-money valuation.
The Series A represents a priced equity financing round, so the SAFE note converts into equity, per the terms of the agreement.
The ownership from the SAFE, Series A price per share is calculated as:
With a 20% discount, investor’s share price is equal to $1.60 per share.
However, due to the valuation cap of $10 million, Investor A’s effective share price is further adjusted:
Since $1.00 per share is lower than $1.60 per share, the angel investor’s cap price is $1.00 per share, wherein the $500k investment amount is converted to 500k shares.
After the Series A, the AI startup has a total of 13M shares outstanding.
Since the angel investor owns 500k shares, the attributable ownership stake is 3.85% of the startup.
Therefore, our hypothetical scenario illustrates that by using the SAFE with a $10 million valuation cap and 20% discount, the angel investor that contributed $500k toward a SAFE note managed to receive shares at better pricing compared to the Series A investors (and now owns 3.85% of the startup for the $500k investment).
The valuation cap and discount evidently benefited the investor relative to the Series A pricing, but the positive outcome was from the liquidity event that materialized.
In closing, the SAFE note provided the early-stage AI startup with the optionality to raise seed funding by granting the angel investor with future equity rights without the need for a premature valuation, from the perspective of the startup.
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