SAFE vs. Convertible Note: Which is Better for a Startup?
Simple Agreements for Future Equity (“SAFE”) and Convertible Notes are two popular funding documents used by startup companies and investors in early-stage funding deals. They are both convertible securities, meaning that the investor provides funding to a startup today with the expectation of converting it into ownership or equity in the company later. They enable you to raise funding sooner while delaying valuation of your startup to a later date when more operational data is available to support the value. With a valuation cap and/or discount in place, SAFE investors and Convertible Note holders are able to purchase equity at a lower price than the equity investors in rewards of their early-stage investments.
Despite their many similarities, SAFEs and Convertible Notes consist of different terms and features that separate one from the other. How do they compare? What are their pros and cons? Find your answers below and make a better decision for your startup.
A CONVERTIBLE NOTE is essentially a loan. The investor initially lends the startup with some money, the principal. The note becomes due on the maturity date, usually one year later, along with the interest accrued at the agreed interest rate. A conversion is triggered by a qualified equity financing event, meaning that the equity financing must come with a valuation exceeding the threshold amount agreed in the note. When the note is due yet no qualified equity funding event happens, you could pay back the note, renegotiate with the investor, or convert it into equity at a pre-agreed price. The note can also be converted into equity in your company whenever both you and the investor agree.
Advantages of Convertible Note
Defer valuation of your startup to a later date, when your startup is more stable and more operational data is readily available to support the valuation.
Not any equity funding event would trigger a conversion, but only the qualified one with valuation exceeding the threshold amount as agreed in the Note Purchase Agreement.
Investors are more familiar with Convertible Notes than with SAFE and hence may prefer Convertible Notes over SAFE.
Legal cost is relatively low to engage an attorney in drafting and negotiating a Convertible Note. You only need one Note Purchase Agreement which would provide substantive terms to many promissory notes you later sign with different investors.
Disadvantages of Convertible Note
A Convertible Note will become due and the maturity date may stress you out. When the note is due and yet not converted, the company may go into bankruptcy if you fail to negotiate with the investor and he demands you to pay back.
Amount due grows larger with interest accruing each day, meaning that you would lose more ownership in your company as the time goes by.
Unlike SAFE, there is no template readily available for a convertible note. You may need to engage an attorney despite the relatively low legal cost.
It is challenging to keep track of your cap table when each Convertible Note comes with a different maturity date and interest rate.
A SAFE is a warrant in nature, providing rights to the investor for future equity in your company. Y Combinator first introduced the SAFE in 2013 with some updates in 2018 and continues to provide standard forms and templates of the SAFE. See YC Safe Financing Documents. A SAFE has no maturity date or interest rate so it never becomes due. An equity financing round automatically triggers the SAFE to convert into equity in your company with no threshold amount required. However, it is not intuitive to track equity dilution and cap table with SAFE funding. Beware of a dilution hit or you may lose control of your company faster than you expected.
Advantages of SAFE
A SAFE helps you raise funding today while deferring valuation of your company to a later date.
Y Combinator provides standardized forms and templates of SAFE. It can save you legal costs in drafting the documents.
A SAFE is one document of several pages long. You won’t have numerous terms to negotiate.
A SAFE has no maturity date or interest rate. So you don’t feel the pressure that it is becoming due.
Each SAFE is a standalone document with no governing master agreement. Hence each SAFE funding is a rather independent transaction with that SAFE investor and can be closed quickly.
Disadvantages of SAFE
Beware of a dilution hit! It is easy to lose track of your cap table especially if you promise SAFE investors certain percentages of ownership using the post-money SAFE.
The SAFE is popular in the Bay Area and among tech startups. It may be less accepted with other investors.
SAFE conversion is triggered by an equity financing event of any size. So you may lose some equities in your company faster than when you use a Convertible Note.