1. Introduction
Early-stage startups often need capital before they're ready for a traditional priced equity round. Two common instruments used for this purpose are SAFEs (Simple Agreement for Future Equity) and Convertible Notes. This guide explains these tools in detail, helping founders make informed decisions about their early funding strategies.
2. Simple Agreement for Future Equity (SAFE)
A SAFE is a contract between an investor and a company that provides rights to the investor for future equity in the company without determining a specific price per share at the time of initial investment.
Key characteristics of a SAFE:
Not a debt instrument
No interest accrual
No maturity date
Converts to equity at a specified trigger event, typically the next priced funding round
Think of a SAFE like pre-ordering a movie ticket. You pay now, but you don't know exactly what seat you'll get until you arrive at the theater. Similarly, with a SAFE, investors buy future equity, but don't know exactly how much until a later funding round.
3. Convertible Notes
A Convertible Note is a form of short-term debt that converts into equity, typically in conjunction with a future financing round.
Key characteristics of a Convertible Note:
Debt instrument that converts to equity
Accrues interest
Has a maturity date
Converts to equity at a specified trigger event, typically the next priced funding round
Imagine a Convertible Note as a gift card that grows in value over time (interest), but has an expiration date (maturity date). When you use it (at the next funding round), it turns into store products (equity).
4. Key Terms and Concepts
Understanding the following terms is crucial for navigating SAFEs and Convertible Notes:
4.1 Valuation Cap
A valuation cap sets the maximum valuation at which the investment converts into equity. It protects early investors from dilution if the company's value increases significantly.
Example: If an investor invests $100,000 with a $1 million valuation cap, and the next round values the company at $5 million, the investor's stake is calculated as if the company were valued at $1 million.
4.2 Discount
A discount offers early investors a reduced price per share compared to investors in the subsequent priced round. The discount is applied to the share price of the priced equity round.
Example:
Priced round share price: $1.00
Discount: 20%
Discounted price: $1.00 - (20% of $1.00) = $0.80 per share
If an investor put in $100,000:
At $1.00 per share, they'd get 100,000 shares
At $0.80 per share, they get 125,000 shares The discount effectively gives them 25,000 extra shares!
4.3 Interest Rate (Convertible Notes only)
The interest rate determines how much the principal amount grows over time until conversion or repayment.
4.4 Maturity Date (Convertible Notes only)
The maturity date is when the note becomes due if it hasn't yet converted to equity.
4.5 Conversion Trigger
The event that causes the SAFE or Convertible Note to convert into equity, typically a priced equity funding round.
4.6 Priced Equity Round
A funding round where the company sells shares at a set price, establishing a clear valuation. This often serves as the conversion trigger for SAFEs and Convertible Notes.
5. Conversion Mechanics
Both SAFEs and Convertible Notes convert to equity based on the terms that provide the best outcome for the investor. The conversion typically occurs at the next priced equity round.
Conversion process:
Determine the price per share for the new equity round.
Apply the discount (if any) to this price.
Calculate the share price based on the valuation cap.
Use the lower of the discounted price or the valuation cap price.
Divide the investment amount (plus any accrued interest for Convertible Notes) by this price to determine the number of shares.
Example: Investment: $100,000 Valuation Cap: $1 million Discount: 20% Next round: $5 million valuation at $1 per share
Calculations:
Discounted price: $1 * (1 - 0.20) = $0.80 per share
Valuation cap price: ($1 million / $5 million) * $1 = $0.20 per share
Use $0.20 per share (the lower price)
Shares issued: $100,000 / $0.20 = 500,000 shares
6. Comparing SAFEs and Convertible Notes
Similarities:
Both convert to equity in a future funding round
Both can have valuation caps and discounts
Both allow startups to delay valuation discussions
Differences:
SAFEs are not debt; Convertible Notes are debt instruments
SAFEs don't have interest or maturity dates; Convertible Notes do
SAFEs are generally simpler from a legal standpoint
7. Impact on Startup Cap Table and Ownership
SAFEs and Convertible Notes can significantly impact a startup's capitalization table:
Dilution: When these instruments convert, they dilute all existing shareholders.
Complexity: Multiple rounds of SAFEs or Notes with different terms can complicate the cap table.
Future Fundraising: The overhang of unconverted SAFEs or Notes can affect future fundraising efforts.
Founders should carefully consider the long-term implications of issuing SAFEs or Convertible Notes on their ownership and control of the company.
8. Conclusion
SAFEs and Convertible Notes are valuable tools for early-stage startup funding. They offer flexibility and allow companies to raise capital without immediately setting a valuation. However, they also come with complexities and potential long-term impacts on company ownership.
Founders should:
Thoroughly understand these instruments before offering them to investors
Consider the long-term implications on their cap table and ownership
Seek professional legal and financial advice when structuring these deals
By using these tools wisely, startups can secure the capital they need to grow while maintaining a clear path to future equity rounds.
9. FAQs
Can SAFEs or Convertible Notes have both a valuation cap and a discount?
Can SAFEs or Convertible Notes have both a valuation cap and a discount?
Yes, they can have both. At conversion, the investor gets the better deal between the two, but not both simultaneously.
What happens if a Convertible Note reaches its maturity date before a priced round?
What happens if a Convertible Note reaches its maturity date before a priced round?
Typically, the company and investors will either extend the maturity date, convert the note to equity at an agreed-upon valuation, or in rare cases, the investor might request repayment.
How do these instruments affect my ability to raise future rounds?
How do these instruments affect my ability to raise future rounds?
Outstanding SAFEs and Notes can complicate future rounds as potential new investors will consider the potential dilution from these instruments when valuing your company.
How are SAFEs and Convertible Notes treated for tax purposes?
How are SAFEs and Convertible Notes treated for tax purposes?
This can be complex and depends on specific circumstances. SAFEs are generally not considered debt for tax purposes, while Convertible Notes are. Always consult with a tax professional for your specific situation.
Can the terms of a SAFE or Convertible Note be negotiated?
Can the terms of a SAFE or Convertible Note be negotiated?
Yes, terms like the valuation cap, discount, and for Notes, the interest rate and maturity date, can often be negotiated with investors.
Which is better for my startup, a SAFE or a Convertible Note?
Which is better for my startup, a SAFE or a Convertible Note?
It depends on your specific circumstances. SAFEs are simpler and more founder-friendly, while Convertible Notes are more familiar to some investors. Consider your investors' preferences and your need for simplicity vs. the structure of debt.
How do valuation caps protect investors?
How do valuation caps protect investors?
Valuation caps ensure that early investors get a minimum percentage ownership when the SAFE or Note converts, even if the company's valuation has increased significantly.
Remember, while this guide provides a comprehensive overview, early-stage funding decisions can have significant long-term impacts on your startup. Always consult with legal and financial professionals before finalizing any funding agreement