Early stage startups often turn to SAFEs and convertible notes for small funding rounds because these cash-efficient instruments are simple to negotiate, flexible, and quick to execute for both investor and founder.

Key Points:

  • A SAFE (Simple Agreement for Future Equity) and a convertible note are both instruments in which an investor provides funds today that can be converted to equity at a later date.
  • A SAFE is considered equity, while a convertible note is considered debt. SAFEs are more prevalent among pre-seed and seed stage startups, while convertible notes may be more prevalent among later stage companies.
  • A SAFE is a cost-efficient way to raise capital for a startup, requiring minimal legal fees when done properly.
  • Many investors prefer a SAFE that offers the “better of” the valuation cap or discount to ensure they are appropriately compensated for the risk they take on investing in an early stage company.
  • Post-money SAFEs are the standard because the investors know their ownership stake, even if a founder has multiple SAFEs with different valuation caps.
  • Limit the number of SAFEs to three maximum (i.e., pre-seed, seed, and a pre-A) and keep it consistent, such as all post-money SAFEs, to understand what you’re selling and avoid dilution surprises later.

For many early stage startups, the need for a capital boost comes long before they’re ready for their first priced round. Founders often turn to SAFEs to fill in the gap between bootstrapping and priced equity rounds. Where a Series A round requires a well-crafted investor pitch deck, extensive negotiation, and significant legal costs, SAFEs and convertible notes can offer a source of funding that’s simpler, faster, and more flexible to negotiate and execute for both investor and founder.

Although they eliminate much of the complexity that comes with a priced equity round, complications can still arise for startups that don’t fully understand the longer term implications of these convertible securities. At a recent RBCx webinar for early stage founders, we spoke with Elizabeth Yin, co-founder and GP at Hustle Fund, and Konata Lake, head of Tory’s Emerging Company and Venture Capital Group at Torys LLP, to glean their insights on what founders should consider with regard to SAFE investments and convertible notes.

Is it debt or equity? The difference between SAFEs and convertible notes

A Simple Agreement for Future Equity (more commonly called a SAFE) and a convertible note are both instruments in which an investor provides funds today that can be converted to equity at a later date. But there are important differences between the two.

A SAFE is considered an equity instrument. “Basically, it’s saying we’ll deal with the equity later,” says Yin. The investor provides the startup funds today but does not receive an ownership stake (via preferred shares) until the company does a priced round.

A convertible note, on the other hand, is an interest-bearing loan with the option to convert some, or all, of the loan to equity. Unlike a SAFE, a convertible note is considered a debt instrument. It carries an interest rate and a maturity date by which the note must either convert to equity or be repaid.

For pre-seed and seed stage companies, SAFEs are used more commonly than convertible notes. “The early stages are so risky, that there’s little appetite to lend money,” says Yin. “So it’s all still in SAFEs as far as what I’m seeing.” Convertible notes are more suited to later stage companies when investors may be concerned with preserving downside protection, especially in today’s economic climateーover the past couple years many startups’ valuations declined.

“The convertible note, perhaps, became more popular than the SAFE for the companies past seed where there’s a bridge. It offered a way to put money into a lot of companies, but with less focus on the ‘hockey stick,’ and more focus on not losing money,” says Lake. “In the worst-case scenario, it’s not equity, it’s debt.”

SAFE vs. Convertible Note at-a-glance 

SAFE Convertible Note
Equity Debt
No interest rate Interest rate
No repayment required Repayment may be required in full or part
No maturity date or term Has a maturity date
Only converts to equity on a priced round Converts on a priced round or at a maturity date

SAFEs are cash efficient for early stage startups

As startups continue to navigate a tough economy, they are increasingly prioritizing cash efficiency over growth at all costs, which makes SAFEs an ideal instrument. The simple and standardized nature of a SAFE helps curb legal costsーparticularly helpful when financing smaller rounds.

“We actively work with our clients to keep costs down… to allow the company to be successful, to grow and have everyone benefit from a much larger, more successful company,” says Lake, adding much of the process is automated to save on costs. “We have a document generator system that will answer a few key questions and then we generate a SAFE. It’s more efficient… we try to minimize the cost to the extent we are involved in a SAFE.”

The SAFE was introduced by Y Combinator and, today, the YC form for a SAFE remains the gold standard. “Ideally what we do when we get to a SAFE is we compare it to the YC form… If it’s very close, and there’s just minor changes, we should be able to look at a SAFE in less than an hour and give you small comments,” explains Lake. “If it’s going to take us longer then you’ve got a document that isn’t really doing what a SAFE is supposed to do.”

Is a valuation cap or discount method better for SAFEs?

A key component of a SAFE is determining how the investment will convert into shares. There are two ways: the valuation cap method or the discount method. In some instances, the SAFE will include both to provide the investors the better of the two and helps ensure the risk they’re taking on will be compensated with the optimal financial outcome.

In the discount method the amount invested will convert upon the priced round at a discountーtypically between five and 20 per cent. For example, if the Series A price per share is $10, and the discount rate is 20 per cent, the investor will convert their SAFE investment into preferred shares at $8 per share. In this scenario, the investor pays a bit less than those coming in on the priced round, and thus gets more shares and a higher ownership stake.

“If you’re raising today and you’re going to do a priced round in a couple years, chances are your company will increase in value, so simply giving a 10, 15, or 20 per cent discount off of the priced round puts the founder in a better position than a valuation cap that may give the investors a bit more of the upside.” It’s a bit of a guessing game, Lake admits, but a simple discount rate is an easy way to structure a SAFE from a founder’s perspective.

In the valuation cap method, the investor and founder agree to calculate the SAFE conversion price based on a valuation limit that will be less than what they expect on the first priced round. For example, if the company today is worth $3 million and is looking to raise when it’s worth $10 million, the SAFE has a valuation cap of $5 million.

“The investor then gets the benefit of that delta between the five and 10,” says Lake. “Investors will convert at that valuation and hopefully accrue some benefit between that valuation cap and what the actual priced round valuation is.”

“It’s a give and take in terms of that discussion with investors around what is the valuation cap or discount. The thinking is that a shared risk should include shared upside.”

When determining which is better, founders should consider the high level of risk investors take on when funding a pre-seed or seed stage startup. “It’s a give and take in terms of that discussion with investors around what is the valuation cap or discount. The thinking is that a shared risk should include shared upside.” This is why some investors prefer a SAFE that offers the better of a valuation cap or discount.

“Meaning when you run the math, whichever gives me the lowest share price, that’s the one I get,” says Lake. “The higher the price [per share] the less I get of the company.”

Determine whether it’s a post-money SAFE or pre-money SAFE

When determining the valuation cap, it’s important for both parties to clarify whether it’s based on a pre-money SAFE or post-money SAFE as that will determine the share price on conversion. The conversion price is calculated by dividing the valuation cap by the company capitalization (which equals the total number of shares and options).

For a pre-money SAFE, the company capitalization does not include the shares issued upon conversion of the SAFE. Since the conversion price does not take into account other SAFEs issued by the company—which can dilute the percentage ownership of all other SAFEs—the investors don’t know how much of the company they will own upon conversion.

“You have to wait to see the math and how it shakes out,” says Lake. “You don’t know how much ownership you have in the company because it’s dependent on how much money is raised on various pre-money SAFEs.”

For a post-money SAFE, the company capitalization includes all shares issued upon conversion. Since the shares that will be issued upon SAFE conversion are included in company capitalization, they are taken into account at the time of conversion so the dilution is borne by the founders, not the SAFE investors.

“An investor knows how much ownership they have, even if the post-money SAFE doesn’t convert for two years, five years, even 10 years,” says Lake. For this reason, post-money SAFEs are the standard. If a founder has multiple SAFEs with different valuation caps, the stakeholders still know their ownership stake based on the document.

Lake recommends both parties be clear on whether the SAFE is pre-money or post-money. “It’s really important because when you do the math, there’s quite a dramatic difference. If the founder is thinking it’s a pre-money valuation cap, but the investors think it’s post money, that can create confusion and not a great situation.”

Keep it simple with multiple SAFEs

Startups can run into challenges when they have multiple SAFEs before their Series A round that don’t connect to one another.

“One of number one issues I see is companies issuing safes that don’t connect into each other.”

“One of number one issues I see is companies issuing safes that don’t connect into each other,” says Lake. “Valuation caps are all different, the discounts are different, and we see when we run the cap table that the founder has low ownership interest because the way the safes work together has diluted them down so much.” He advises modelling the scenarios out now to avoid dilution surprises later. “Always try to have a cap table model and enter the calculations in there.”

Yin advises founders to limit the number of SAFEs to three tranches maximum, such as a pre-seed, seed, and a pre-A. The key to effectively managing multiple SAFEs is simplicity and understanding what you’re selling: “If you do it on post-money SAFEs, then you know exactly how much is converting, like $500K on X, $1 million on Y, $2 million on Z, and add it all up. That’s how much of the company you’ve sold.”

Test the waters to determine the right valuation cap

Determining the valuation can be a challenging endeavour for an early stage startup. Yin suggests thinking about valuation in terms of supply and demandーthe demand from investors and the supply of your round. A founder with multiple interested investors has more leverage to drive up the valuation than a founder with only one or two interested parties.

Founders can also figure out the dynamic of their supply and demand by testing the waters with a few investors by simply asking for their opinion. “Go out and say, ‘I’m not raising right now, but I would love to get your feedback because I’m thinking about raising soon. What sort of valuation do you think something like this might fetch?” says Yin. “The investor will probably give some sort of range to give you a sense [of your company’s worth].”

Alternatively, she recommends raising “a very small tranche on favourable terms” and gauge the ease with which it is filled to adjust your valuation cap as needed.

SAFEs and convertible notes offer early stage founders the opportunity to raise necessary capital without the complexity that comes with raising venture capital through priced rounds. “There are so many more founders than lead investors,” says Yin, indicating that the probability of raising from a lead investor isn’t high. “You can raise on stage from angels and smaller investors as well on SAFEs, without having a lead, so you know most of the rounds getting done successfully are on SAFEs.”

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