When you are considering your options for seed investment, you ideally want to find a low or no interest option that provides fundraising upfront, with fewer restrictions for repayment or equity when conversion time comes around. Since this is the best way to find something to suit your short and long-term goals, the two most logical options are simple agreement for future equity (SAFE) notes and convertible notes. Here’s how you can decide which one is best for you.
What is a Convertible Note?
A convertible note works like debt, that provides your startup with funding in exchange for investors’ rights to convert their investment into equity. The conversion takes place at an agreed-upon milestone called a maturity date. Because the convertible note is considered debt, it also has interest applied. When the note hits the maturity date, it automatically converts into shares of preferred stock. The maturity date and interest rate make the investment safer for investors and riskier for founders. The convertible note is also more complex in its terms and therefore more costly and prone to complicated negotiations.
What is a SAFE?
SAFEs are not a debt so do not require a maturity date or interest. Instead, they are considered a warrant that entitles investors to purchase stocks at a special price but only at the next priced round. Because there is no maturity date or interest rate, the risk is reduced for the founder and increased for the investor.
What Similarities are there Between Convertible Notes and SAFES?
For both investments, founders have an excellent way to overcome financial challenges as they struggle to establish themselves. They are viable options that bring in funding in similar ways allowing founders to reach the key milestones that lead to a Series A round of stocks. When it comes to conversions, they both offer discounts to investors who can purchase shares once the first event occurs. However, what makes it easier to decide which one is best for you, is actually considering the differences outlined in the seed investment terms.
How Founders can Decide Between SAFE and Convertible Notes
While it really depends on your personal preferences and type of business, there are a few things you should consider when choosing the best seed investment option for your startup:
The Terms
Many startups are attracted to the terms laid out by a SAFE. Consisting of a simple five-page document, it really helps speed up the seed investment process while eliminating the need for interest and maturity dates.
Conversion Equity
As mentioned, both investments offer investors a form of converting their notes into equity, albeit on different terms. So with convertible notes, the conversion can be offered either at the current round of stocks or in the future, you can only convert a SAFE note in the next round. What can prove scary depending on the financial health of your company is that should the triggering event occur at a time the money raised is quite low, it could prove detrimental to your business. This is one of the reasons some startups choose the convertible note instead.
Valuation Caps and Discounts
You have to do your math to understand the risks of what is referred to as dilution. Equity dilution occurs when caps and discounts are overly generous allowing investors to afford to purchase more shares. When this happens, investors can end up with a higher percentage of ownership than you imagined, which can impact control. It can also make it more difficult to raise interest when it comes time for your Series B funding. So you have to consider how your valuation caps and discounts when raising your Series A, can dilute your shares and interfere with Series B.
Early Exits
Although the payout mechanisms for early exits are quite similar between the two, with SAFE notes, the investor has a choice between a single payout or conversion into equity at the cap amount. With a convertible note, however, there is usually a two times payout provision. Keep in mind you do have the option to write this into a SAFE agreement. Early exits occur when your company either merges with another company, or you choose to sell.
Interest Rate and Maturity Date
The debt aspect of the convertible is probably one of the most important considerations. You don’t have to worry about interest for SAFEs. With the convertible note you can look at interest rates that average about 5%. While they can be low as 2%, they can be even higher than five reaching 8% in some cases. This adds an additional expense to your debt burden which is what makes the SAFE so attractive to many founders.
And let’s not forget the maturity date for convertible notes. When you reach the maturity date you either have to pay back the principal investment plus interest or convert the debt into equity. Both options have the potential to lead to financial stress or even insolvency. Between the interest and maturity date, SAFEs tend to reduce risks.
Although the SAFE option tends to come out ahead, it’s always best to consider all the terms before deciding which seed investment offers the best opportunity.
