When it comes to fundraising, startups have a number of instruments at their disposal. In the last decade it has become exceedingly rare to raise early rounds of startup funding (Friends and Family and Pre-Seed) through an equity investment because doing so required investors and founders to agree upon a valuation when the company is at the concept stage. Additionally, equity rounds tend to be more costly, complex and time consuming.
So, instead of raising equity, the most common instruments for early rounds of funding are convertible notes and SAFEs.
What is a convertible note?
A convertible note is a type of fundraising instrument that can be used by early-stage startups to raise capital. Essentially, a convertible note is a loan that can be converted into equity upon the occurrence of certain events, the most common such event is when the startup raises a certain amount of money in a subsequent funding round.
What is a SAFE ?
A Simple Agreement for Future Equity (SAFE) is a contractual agreement between a startup company and its investors. It is an agreement where the investor’s capital is exchanged for the right to purchase preferred shares in the startup company when the company raises a future round of funding. The SAFE sets out conditions and parameters on when and how the capital would convert into equity.
How are convertible notes different than SAFEs?
The two instruments often achieve the same objectives, but they differ on the following two key points.
- Timing: Convertible notes have a firm maturity date, typically 2-3 years. If the conversion doesn’t occur by that date, then the agreement either needs to be re-negotiated and extended or paid off (more on that below). Conversely, there is no maturity date on a SAFE, so there’s no time pressure to convert. Thus the SAFE creates a more flexible time window for startups.
- Repayment: There are different implications for the startup depending on the instrument. If a convertible note does not convert into equity before the maturity date then, the company owes the investor the total amount invested plus accrued interest. However, with a SAFE, if it does not convert, the company owes the investor nothing.
Which is better for a startup, a SAFE or Convertible Note?
Both SAFEs and convertible notes offer a way for startups to raise capital without requiring an immediate valuation, but they differ in timing and repayment. All things being equal SAFEs are simpler and more flexible than convertible notes and have therefore become the fundraising instrument of choice for early stage startups.
Of course, there’s no one size fits all answer to this question. When deciding which fundraising instrument to use, startups should work with counsel to consider several factors, such as the company’s stage of development, timeframe for raising funds, investor preferences, and exit strategy. If you’re looking for counsel, feel free to reach out to us here.
If you want to dive deeper into these funding instruments, check out our Founder’s Guide to Convertible Notes and Founder’s Guide to SAFE.