A convertible note and a SAFE (Simple Agreement for Future Equity) are both financial instruments used by startups, especially in the early stages, to raise capital from investors without having to set a valuation for the company. While they have some similarities, they have some significant differences that are important for companies and investors to understand.
- Debt vs Equity:
- a. A convertible note is a debt instrument. When an investor invests in a startup through a convertible note, the investor is lending money to the company, and the note is the debt owed by the company to the investor and is accounted for on the books and records of the company as debt. The investor has the option to convert the debt into equity at a later date, which is when the debt converts to equity.
- b. A SAFE is not a debt instrument; it is an equity instrument. When an investor invests in a startup through a SAFE, the company is granting the investor a right now to receive shares in the company in the future.
- Terms:
- a. Convertible notes can have an interest rate, which means the investor could earn interest on the principal amount until redemption or conversion of the note. Additionally, convertible notes have a maturity date, by which the company must either repay the note or convert the debt into equity.
- b. SAFEs do not accrue interest like convertible notes, so they do not have an interest rate and they do not have a maturity date. They remain outstanding until they are converted into equity or until certain events specified in the SAFE trigger a cash redemption by the investor.
- Mechanics of Conversion into Equity:
- a. Convertible notes can include additional conversion triggers such as optional conversion at the option of the holder at maturity, when certain qualifying transactions occur or when the investor and company mutually agree to convert.
- b. SAFEs typically only convert at a future financing round. SAFEs can have additional terms such as Most-Favored Nation (MFN) provisions and pro-rata purchase rights built into the SAFE or included in a side letter.
- Legal Complexity and Cost
- a. Convertible notes are generally more complex and involve more negotiation and legal documentation, including interest rates, maturity, conversion terms, and other terms. Thus, it can take longer to negotiate and enter into convertible notes, making convertible notes more legally expensive than SAFEs.
- b. SAFEs were introduced as a simpler alternative to convertible notes, with streamlined forms including the Y Combinator forms of SAFE, and removal of certain terms such as interest rates and maturity dates, so that negotiated and entering into a SAFE would be faster, easier and cheaper.
Both convertible notes and SAFEs typically convert to equity at a company’s future financing round, and the conversion can be based on similar terms like a valuation cap (where the conversion is based on a maximum negotiated ceiling on the valuation even if the future financing round is at a higher valuation) and/or a discount rate (where the conversion is based on a certain negotiated percentage of a discount from the price paid by new investors in the future financing round). If a SAFE or convertible note include both a discount rate and a valuation cap, the investor typically can take advantage of whichever of the two conversion methods gives them the lower conversion price per share (i.e. they can get more shares for less money).
Both convertible notes and SAFEs have pros and cons, and the choice between the two depends on the preferences and circumstances of the startup and the investors involved. Startups and investors seeking to use these instruments should consult with legal counsel to determine the best fit for their specific needs.
