SAFE or Convertible Note?

Should I offer investors a SAFE or a convertible note? What’s the difference and is one always better than the other?

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This is one of those questions that we run across frequently, so today we’ll present other people’s answers to these questions. Please note, this isn’t legal advice and you shouldn’t use it as such.

Definitions

Convertible Note

A convertible note is a type of debt that has the right to convert into equity when a company hits an agreed-upon milestone, typically the next round of funding. If the milestone isn’t hit, the company owes the investors their original capital plus interest. Cite.

SAFE

A SAFE, or Simple Agreement for Future Equity, is “an agreement between an investor and a company that provides rights to the investor for future equity in the company similar to a warrant, except without determining a specific price per share at the time of the initial investment.” Cite

Background

Historically, a convertible note has been used by early-stage investors and startups to facilitate an investment relationship that functions like equity without all the risks. Early stage equity investments are risky for investors because they don’t get paid back if the company fails. And they’re risky for companies because they often have no idea how to set a valuation on an idea in its infancy and end up having to give away a lot of the equity (and therefore control) too early.

Ed Zimmerman, a VC lawyer who also teaches at Columbia, explains the history of convertible notes.

During the last decade, founders have increasingly used convertible notes as the mechanism of choice for seed funding. Convertible notes help founders and investors sidestep the friction of agreeing on a valuation for the startup. However, using convertible notes to fund a startup entails agreeing that the notes will convert into the next round of funding – this kicks the can down the road forcing the next set of investors to ‘price the deal.’ Note rounds can be shorter, simpler and faster than preferred stock financings.

The article goes on to explain some of the common pitfalls. It should be required reading for any founder or investor considering a convertible note round.

A quality convertible note investment requires negotiating a lot of terms, including the valuation cap, liquidation preference, and exact terms of the triggering event. Again, read Zimmerman’s article or others to better understand these terms and potential problems with not addressing them properly.

Y Combinator invented the SAFE as a way to make it easier to invest in early-stage, fast-growing tech companies. YCom remains the chief proponent of SAFEs and offer many helpful sample documents on their website.

The SEC explains where SAFEs work well:

SAFEs were developed in Silicon Valley as a way for venture capital investors to quickly invest in a hot startup without burdening the startup with the more labored negotiations an equity offering may entail. Oftentimes, for the venture capital investor, it was more important to get the investment opportunity, and possible future opportunities, with the startup than it was to protect the relatively small investment represented by the SAFE. In addition, the various mechanisms of the SAFE, from the triggering events to the conversion terms, were designed to best operate in the context of a fast growing startup likely to need and attract additional capital from sophisticated venture capital investors.

Read the whole article, including the SEC’s warnings here. SAFEs can be great in certain situations, where (1) the company and investors understand the effect of conversion on the future cap table, (2) in a high growth company where an equity round will follow closely behind the SAFE round. In many others, many feel they create an unfair disadvantage for investors who risk capital in a very early-stage company. This article explains the pros and cons well.