What the heck is the difference between Convertible and SAFE notes? YES!
We will answer that question for you in this blog but before that here is what we want you to truly understand.
“No matter what valuation you have, the true value of your startup is always determined by the market”.
It’s always the market. Consumers like you and me. To project their growth to impact people’s lives, a startup needs funds.
Funds are obtained in many ways for which you can read our blog – Fundraising for Startups.
Today we are only focusing on two slightly confusing ways – which I hope would not be as confusing post this blog in Convertible and SAFE notes.
Convertible securities are financial instruments issued by a startup to secure funding from an investor that can be converted into equity after a specific period of time.
Convertibles aren’t exactly equity, but equity-linked securities. Here, the firm doesn’t raise capital by issuing shares of the company to an investor.
Moreover, they aren’t completely debt either, as the founder isn’t taking a loan from a backing entity, like the government, with an obligation to pay back principal and interest within a defined time period.
Whenever any convertible instrument is used, both the founder and the investor intend to have it converted to equity at a later schedule.
There are 2 types of convertible securities – Convertible Note and SAFE Note. Understanding them is crucial before knowing about the subsequent differences.
Convertible Notes are short-term debt instruments that are supposed to be converted into equity in conjunction with the startup’s subsequent financing round. When investors are approached for funding, this instrument ensures that the aspect of a loan with principal and interest is returned via equity of the company at the next trigger event.
In case the event does not occur, the investor has the right to be repaid in principal along with the accrued interest. Both the entities, however, intend for equity conversion to happen.
SAFE Notes (Simple Agreement for Future Equity) are somewhat similar to Convertible Notes except that the entire hassle of loan, interest, and maturity date is absent.
They originated in 2013 by a startup accelerator named Y Combinator solving the pain points of thick legal paperwork, impending maturity date, and lengthy procedure founders face whilst securing funding.
There’s minimal paperwork (6 pages) to be signed to kickstart this funding process.
7 Key Differences between Convertible Notes and SAFE Notes
1. On the basis of Interest Rates
SAFE Notes are alternative to Convertible Notes in a way that they aren’t debt instruments. They don’t carry the aspects of either interest rates or impending maturity date.
Convertible Notes accrue interest to be repaid by a certain date if the financial round does not occur or fails to raise expected funding.
Interest typically ranges between 2% – 8%.
2. On Trigger Events
Convertible Notes permit conversion on 2 conditions –
- either into the current round of shares,or
- into the subsequent future financing event where stocks are issued to the seed investors.
On the other hand, SAFE Notes permit conversion only into the next financing round when the shares are priced.
3. On Maturity Period
As mentioned before, SAFE Notes don’t create an obligation for the company to commence conversion after a scheduled time period.
Convertible Notes do come with such an obligation. In case the date passes before the financial round occurs, the investor can take certain actions –
- The equity is converted into debt
- The maturity date is negotiated again
- Repayment of both principal and interest
In the third scenario, the company runs a risk of declaring bankruptcy.
4. On Terms
SAFE Notes are easier to execute and hence, can be issued to more than one investor with more than one valuation cap agreement.
They’re standalone documents flexible to be issued at different times with separate terms for each respectively.
Convertible Notes, however, are legally highly cumbersome as they include trickier agreements of maturity dates and interest rates. They consist of multiple documents like Promissory Note, Note Purchase Agreement, Voting Agreement, and more.
5. On Conversion to Equity
The conversion event for both Convertible and SAFE Note is the same – subsequent financing round (like series A) or exit event (like IPO).
It is advisable that the founders do their own Dilution Math to know how much of ownership is going to be diluted after the conversion when it comes to terms of Discount and Valuation Cap.
A lot of times, entrepreneurs forgo doing Dilution Math on the cap table and end up losing more ownership than they initially anticipated.
Moreover, because SAFE Notes can be issued multiple times to a plethora of investors, the calculation becomes increasingly complex through several Discounts and Valuation Caps involved.
6. On Early Exits
In both the agreements, a change of control of the company (through M&A or IPO) is anticipated and clauses are constructed in favor of the seed investor.
SAFE permits either 1X payout or conversion into equity at the valuation cap amount while Conversion Note typically permits 2X payout provisions or conversion into equity at cap amount in the buyout event.
It is the choice of investors to go for any one of these options and select the mechanism which benefits them the most.
7. On Investor Familiarity
If the SAFE Note is the choice of seed financing instrument agreed upon by both the investor and the founder, chances are that the investor is also familiar with the Conversion Note and will be game to work with both.
In the case of the choice being a Convertible Note, the investor may not be familiar with the SAFE Note, thereby not having risk tolerance for instruments that don’t provide the security of accrued interest.
With the investor-friendly clauses of Convertible Notes – interest, maturity, time-based agreement, and more – the investor may not go for a simpler form of agreement.
|Convertible Notes||SAFE Notes|
|Funding||The investor loans capital to the startup which can be either converted into equity or repaid in full principal and||The investor provides capital to the startup which can be converted into equity in case the subsequent|
|interest||financial round occurs|
|Accrued Interest||The Note specifies the interest rate along with the modality of calculation. The interest is accrued throughout the period till the time maturity or financial round occurs.||There is zero interest on the issuance of the SAFE Note|
|Trigger Conversion Event||Conversion is allowed into the current round of shares, the next financial round(s), or exits events||Conversion is allowed into the next financial rounds and exit events|
|Valuation Cap||This is subject to negotiation. This is an investor-friendly term that allows the investor to buy the share at priorly agreed prices rather than higher ones in case the later valuation is more than the cap||They also consist of this term for the seed investor|
|Discount||This is also an investor – friendly term permitting the seed investor to buy shares at a priorly decided discounted price rather than the one set later||Discount is one of the ways founders are able to attract seed investors to take a high risk and reward them for it|
|Conversion Rate||This is calculated keeping the interest rate into account||Accrued interest doesn’t play a role in deciding the rate|
|Terms||Important stipulations like not reaching the conversion event despite nearing the maturity date are set up on the choice of the investor||This is just a standalone document consisting of 5 – 6 terms with minimal terms|
The Indian startup ecosystem is attracting billions worth of foreign and native investments.
More startups are issuing Convertible Securities as a form of an accessible funding option in collaboration with legal and FinTech sectors.