Safe (Simple Agreement for Future Equity) notes and convertible notes are mostly used to fundraise for start-ups and high growth ventures. The two notes are commonly applied to raise more funds in priced equity rounds. If you have a new start-up and wonder which one to choose between SAFE notes or convertible notes, this article will give you some pointers and help you weigh your options.
Definition of Safe and Convertible Notes
A convertible note refers to a kind of debt that can usually convert to equity once the agreed-upon milestone is reached. Convertible notes are structured the same as loans. Nonetheless, after a round of financing is closed, a convertible note automatically becomes shares of preferred stock. A SAFE note is a very short document that warrants purchased stock in future priced rounds.
Advantages of a Safe Note
- The note is very straightforward and short and does not require much expenses and constraints. Most entrepreneurs prefer it due to this factor.
- It is well-suited for organizations that require short-term, lesser funds to take them to the next big round of investment.
- They do not have a date of maturity.
- A SAFE note gives little control to an entrepreneur since there does not exist a minimum amount to be fundraised to trigger the conversion.
- When converting, the founders have to anticipate dilution after they convert since some people may find themselves with greeter dilution than anticipated at the SAFE’s signature.
Advantages of a Convertible Note
- The trigger of conversion for a convertible note is a result of qualifying events. This means that both parties have to agree in the conversion, or they have to convert the amount agreed upon in the agreement.
- There is a higher level of control with convertible notes, and this makes them appeal more to most start-ups.
- Convertible notes are very complex and usually longer than SAFE Notes.
- With a convertible note, a company is always at a higher risk of bankruptcy because convertible notes still remain to be debts even when companies are not doing so well.
Similarities between a Safe Note and a Convertible Note
- They both bridge real funding milestones such as seed rounds
- Both are fast and cheap to implement compared to full-priced rounds
- Both may include similar terms within, for instance, MFN, discounts, converting predominantly into similar share class as the following round, and pro-rata rights
How Do Convertible Notes and Safe Notes Work?
A convertible note is known to postpone the need for agreeing on a pre-money valuation done of an organization before investing. A convertible note, which is usually a loan, contains a fixed term, and its rates of interest accrue gradually. One can negotiate the interest rate, and this may depend on how much you and your investors want to invest in that start-up.
Once the term ends, the investors will tell you whether they prefer having their principal and interest back, or they would rather convert the loan to shares in your company. A start-up may choose to give the investors a discount or convert their notes to shares as they gave an unsecured loan to a risky venture.
SAFE notes, on the other hand, do not convert to equity. They also do not have discounts or valuation caps. You and your investors have to decide on how much you are willing to sacrifice in making the deal happen.
Although SAFE notes and convertible notes are somehow similar, they have some notable differences. The SAFE note is seen as more straightforward and does not include a lot of burdens. However, they carry more risks for investors. Convertible notes, although heavier in implementation, are safer, thus preferred by most start-ups. Therefore, you need to understand the one that suits your situation best before making a choice.