Startup Funding: SAFE vs Convertible Note

SAFE or convertible note? That is the question.

Startup founders typically raise their initial capital from family, friends and angel investors. As you may be aware, SAFEs and convertible notes are the most commonly-used instruments for these early-stage investments.

This article will provide an overview of SAFEs and convertible notes and highlight the main differences between each type of security.

I. SAFE

The SAFE was created by Y Combinator in Silicon Valley more than a decade ago and has primarily been used by US investors. Over the last several years, Canadian investors have increasingly adopted the use of SAFEs.

SAFE stands for “Simple Agreement for Future Equity.” As its name suggests, a SAFE is an investment contract for future equity ownership in a company. Under the terms of a SAFE, an investor’s investment amount will automatically convert into shares of the company when the company completes an equity financing.

Conversion: The conversion price can be based on (1) the share issuance price in the future equity financing, (2) a discounted price to the share issuance price in the future equity financing, or (3) a pre-determined equity ownership percentage of the company.
Valuation Cap: A valuation cap imposes a maximum company valuation at which the SAFE investment would convert into equity. This provision protects the investor by limiting the conversion to a capped company valuation where the company completes an equity financing at a company valuation higher than the valuation cap.

II. Convertible Note

A convertible note is a debt instrument that can be converted into equity of the investee company. Under the terms of a convertible note, the principal and accrued interest amount will automatically convert into shares of the company when the company completes an equity financing.

Maturity Date: If the convertible note has not converted into shares by the maturity date, the principal and accrued interest on the note will need to be repaid to the investor.
Interest Rate: Interest will accrue on the convertible note and will be payable at maturity unless the note has previously converted into equity.
Automatic Conversion: The conversion price can be based on (1) the share issuance price in the future equity financing, or (2) a discounted price to the share issuance price in the future equity financing. There may also be a valuation cap imposed on the conversion price.
Voluntary Conversion: Prior to the maturity date, the investor may have an option to convert the principal and accrued interest amount into shares at a pre-determined valuation of the company.

III. Key Differences Between SAFEs and Convertible Notes

A convertible note represents a debt obligation on the part of the issuing company. If no conversion has taken place and the company has not repaid the loan by the maturity date, the investor can pursue legal action against the company and seek to enforce repayment of the loan.
A SAFE is not a debt obligation and, therefore, there is no repayment obligation to an investor at a specified maturity date.
Since a convertible note represents indebtedness of the issuing company, any money payable to an investor under the note would have priority over any payments to an investor under a SAFE.
The interest payment obligation on a convertible note makes it a more expensive form of financing as compared to a SAFE, without taking into account any discounts to the future share issuance price.

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This article is for informational purposes only and does not constitute legal advice.

For more information about SAFEs and convertible notes, contact David Kim of Crescendo Law at [email protected]. To learn more about Crescendo Law, visit our website at https://creslaw.com.