In the ever-shifting landscape of early-stage startup funding, the choice between Simple Agreements for Future Equity (SAFEs) and Convertible Notes is a critical decision. As entrepreneurs embark on the journey of securing pre-seed funding, understanding the nuances and key terms associated with these financial instruments becomes paramount.
As startups seek to raise capital in their earliest stages, the financial instruments employed often include SAFE agreements and Convertible Notes. These tools provide a flexible and cost-effective means for entrepreneurs to secure funding from angel investors and navigate the complexities of pre-seed capital acquisition.
Both SAFEs and Convertible Notes share the common goal of offering early-stage investors the right to convert their investment into preferred stock in the next sale of preferred stock (referred to in the startup world as “priced rounds”). However, the crucial distinction lies in their nature.
In the realm of startup funding, the choice between SAFEs and Convertible Notes is pivotal. SAFEs, designed as equity instruments, stand out for their simplicity and absence of debt-like features. They convert into preferred stock during the next priced round, offering a fully standardized and startup-friendly approach in a compact 6-page document. In contrast, Convertible Notes, deemed debt instruments until they convert to preferred stock, involve more complexity because they are not as standardized and thus have much more customized terms that are always subject to negotiation. Convertible Notes potentially span multiple documents and thus tend to require higher legal fees. While less standardized, they are favored in some cases by investors for their protective features.
The choice between using SAFEs vs Convertible Notes often hinges on transaction simplicity, cost-effectiveness, and the preferences of both startups and investors.
Discount and Valuation Cap: Essential to both SAFEs and Convertible Notes, the discount (typically 10-20%) and valuation cap (commonly ranging from $6-15 million for pre-seed funding) determine the conversion terms during subsequent priced rounds (learn the mechanics of how valuation caps and discounts work).
Pre-money and Post-money Valuation Cap: While pre-money valuation caps were prevalent in the early days of the SAFE agreement, post-money valuation caps have become more common in both SAFEs and Convertible Notes. Post-money valuation caps offer simpler math for determining the investor's ownership percentage because the percentage for each investor is not contingent on the amount of SAFEs or Convertible Notes sold to other investors (whereas the ownership percentage under a pre-money valuation cap hinges on the amount raised from other investors). This ensures clarity in conversion mechanics for both the company and investors.
Most Favored Nation (MFN) Rights: An investor with MFN rights ensures that if subsequent SAFEs or Convertible Notes are issued with more favorable terms, they are entitled to those benefits. Although relatively rare, it serves as a protective clause for early investors.
Liquidation Preference: In the event of an acquisition of the company before conversion, the liquidation preference safeguards the investor's interest, commonly set at 1x or based on the terms they would have received upon conversion. In other words, if the company is acquired before the SAFE or Convertible Note converts, the investor typically will receive the greater of its money back or the amount of money they would have received had conversion occurred prior to the acquisition.
Maturity Date: Typically ranging from 12 to 24 months, the maturity date represents the period within which the startup should ideally progress to a priced round. After this term, the investor theoretically has the right to demand repayment. All Convertible Notes have a maturity date while SAFEs do not.
Interest Rate: Typically ranging between 6-10%, the interest rate on Convertible Notes ensures the value of the investment increases over time, adding another layer of return for the investor.
Secured vs. Unsecured: Pre-seed Convertible Notes are generally unsecured, avoiding the complexities associated with securing assets or intellectual property. All Convertible Notes have interest while SAFEs do not.
Conversion Threshold and Voluntary Conversion: Investors may stipulate a minimum threshold for conversion and reserve a voluntary right to convert if the startup raises less than the specified amount in a priced round. These terms may be present in some Convertible Notes and absent in others depending on the negotiation between the parties.
Maturity Conversion: In some Convertible Notes, the investor can choose between converting into preferred or common stock based on predetermined terms, or retain the right to demand repayment upon maturity.
Ability to Prepay: Typically not permitted by investors, startups rarely have the ability to prepay Convertible Notes as investors are more interested in equity participation than immediate repayment.
Note Purchase Agreement vs. Standalone Notes: Convertible Notes can be standalone agreements or part of a coordinated approach where lead investors set terms for the entire round, influencing aspects like maximum funding limits and timelines.
The mechanics of SAFEs and Convertible Notes differ. SAFEs involve board approval, followed by a straightforward negotiation and signing process. In contrast, Convertible Notes entail term sheet-level negotiations, board approval, and the subsequent signing and funding of more involved legal documents.
As startups grapple with the decision between SAFEs and Convertible Notes for pre-seed funding, the overarching recommendation leans toward SAFEs, given their simplicity, cost-effectiveness, and favorable terms for startups. However, the ultimate choice depends on negotiation leverage, investor preferences, and the unique dynamics of each funding scenario.
Understanding the intricacies of these financial instruments empowers startups to navigate the complex terrain of pre-seed funding with confidence.
While priced rounds can be used for pre-seed funding, the data (in a broader industry context) reveals a noteworthy shift in the prevalence of SAFEs and Convertible Notes for funding rounds where at least $1 million was raised and such funds were the first investment into the company. In 2020, only 38% of such rounds were structured as SAFEs or Convertible Notes (while the remaining 62% were structured as priced rounds). By contrast, in the first half of 2023, 65% of such rounds were structured as SAFEs or Convertible Notes (and only 35% were structured as priced rounds).
Digging deeper into those numbers, SAFEs have increased in such rounds from 24% in 2020 to 50% in the first half of 2023.
Understanding these trends provides startups and investors valuable insights into the evolving landscape of pre-seed funding, aiding strategic decision-making in an ever-changing financial ecosystem.
Embark on your startup's financing journey with confidence. Leverage the expertise of SPZ Legal to navigate the nuances of SAFEs and Convertible Notes. Whether you're a founder seeking clarity or an investor evaluating terms, our team is here to guide you.
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