When raising funds for a startup, particularly during early stages, founders often look for investment structures that are both simple and flexible. Two of the most popular instruments for early-stage financing are Convertible Notes and SAFEs (Simple Agreements for Future Equity). Both provide a way for startups to raise capital without immediately valuing the company. However, they have key differences that make them suited for different scenarios. Let’s break down what they are, how they work, and when to use each.
What is a Convertible Note?
A Convertible Note is a debt instrument that startups issue to investors, where the loan eventually converts into equity. Here’s how it works:
- Loan-Based Structure: The investor loans money to the startup, expecting it to be paid back with interest if the conversion event (typically the next financing round) doesn’t happen.
- Conversion Event: The debt converts into equity at a future round of funding, usually at a discount or with a valuation cap (which limits the maximum price at which the note converts).
- Interest Rate: Convertible notes accrue interest, usually ranging between 2% and 8%. This interest can be paid back in cash or converted into equity along with the principal amount.
- Maturity Date: Convertible notes have a maturity date by which the debt either converts into equity or is repaid if a qualifying financing event hasn’t occurred by that time.
When to Use Convertible Notes
- Uncertain Valuation: Convertible notes are ideal for early-stage startups where it’s challenging to determine a fair valuation. The company can defer the valuation until a more significant funding round.
- Time-Sensitive Deals: If a startup needs to raise money quickly, convertible notes allow founders and investors to avoid protracted negotiations around valuation, enabling fast fundraising.
- Debt-Like Features: Startups may use convertible notes when they want to offer investors the added security of a loan. The inclusion of interest and a maturity date provides downside protection for investors.
What is a SAFE (Simple Agreement for Future Equity)?
A SAFE is an agreement between a startup and an investor in which the investor provides capital in exchange for the right to purchase equity at a future financing round. Unlike a convertible note, a SAFE is not a debt instrument. Key features include:
- Equity-Based Structure: SAFEs don’t carry interest or maturity dates, making them simpler and more flexible than convertible notes.
- Conversion Event: A SAFE converts into equity at a future funding round, often with a discount or a valuation cap, just like a convertible note.
- No Repayment Obligation: Since SAFEs are not debt, there’s no obligation for the startup to repay the amount if the company fails to raise another round of funding.
- Simpler Structure: SAFEs are much more straightforward than convertible notes because they don’t include debt-related provisions like interest or maturity.
When to Use SAFEs
- Pre-Seed or Seed Rounds: SAFEs are commonly used for early-stage fundraising rounds when the startup wants a quick and straightforward investment agreement without the complexities of debt instruments.
- Valuation Flexibility: SAFEs allow founders to defer formal valuation until a larger funding round, just like convertible notes, but without the constraints of debt and maturity dates.
- Founders’ Preference: If founders prefer a simpler agreement that doesn’t require dealing with debt, interest rates, or the pressure of repaying investors, SAFEs are often the preferred choice.
Key Differences Between Convertible Notes and SAFEs
| Feature | Convertible Notes | SAFEs |
|---|---|---|
| Instrument Type | Debt (loan with interest) | Equity Agreement |
| Interest | Accrues interest (typically 2-8%) | No interest |
| Maturity Date | Yes, a fixed date for repayment or conversion | No maturity date |
| Repayment Obligation | Loan must be repaid if no conversion event occurs | No repayment obligation |
| Investor Security | Some security through debt provisions | No debt or security; equity conversion only |
| Complexity | More complex with loan-related provisions | Simpler structure, less negotiation required |
Which Should You Use?
Convertible Notes and SAFEs both serve similar purposes: deferring valuation until a later funding round while providing investors with equity. However, deciding which one to use depends on the specific circumstances of your startup and the needs of your investors.
When to Use Convertible Notes
- For Investors Wanting Downside Protection: Investors who want more security might prefer convertible notes because of the debt-like structure, interest, and the repayment option.
- In Case of Longer Timelines: If your startup expects to take a longer time between rounds or might not raise another round, the maturity date and interest in a convertible note can provide investors with confidence.
When to Use SAFEs
- For Simplified Deals: If you’re seeking a fast and straightforward agreement, SAFEs are much easier to implement.
- For Very Early-Stage Rounds: SAFEs are often more suitable for pre-seed and seed rounds where investors and founders both prioritize speed and simplicity over complex debt structures.
- When No Debt Is Desired: Since SAFEs don’t involve debt, they can be more founder-friendly, reducing the financial risk associated with owing money if a future round doesn’t occur.
