In 2014, the Silicon Valley startup accelerator, Y Combinator, developed a novel startup fundraising strategy that it was dubbed the “simple agreement for future equity”, or “SAFE”. Both SAFE agreements and convertible notes give an investor the opportunity to receive equity in a startup company at a later date. Startups should have a solid understanding of the seven key differences between the two strategies to determine if either option is appropriate for their early fundraising needs.
1. When does equity conversion occur?
Both convertible notes and SAFE agreements can convert to equity, but equity conversion under a SAFE agreement generally happens only when a startup completes its next round of angel or venture financing. SAFE agreements are ideal for companies that need a short-term, lesser amount of funding that will carry them through to the larger round. That larger round then automatically triggers an equity conversion for the SAFE investor, regardless of how much funding is raised. Alternately, convertible notes usually convert to equity upon the occurrence of defined qualifying transactions or whenever the parties agree that they will convert. Startups have more control over equity conversions with convertible notes, which may appeal to entrepreneurs that are reluctant to give up equity in their companies.
2. What are the respective interest rate obligations?
SAFE agreements are essentially options to purchase equity at a later date, and as such they do not include an interest component. Convertible notes, on the other hand, are debt instruments that do incur interest. Interest payments on convertible notes typically accrue into the note’s principal balance, adding to the total amount of equity that will be issued to the investor on conversion.
3. Do SAFE agreements have maturity dates?
Because SAFE agreements are not debt instruments, they do not have maturity dates, and startups that receive funding through SAFE agreements will not face any future principal repayment deadlines if a conversion will not occur. With a convertible note, a startup is obligated either to repay principal or to convert the debt to equity on a specific maturity date or upon occurrence of certain other conditions, such as the startup’s raising additional capital above a threshold amount.
4. What other fundraising options does a startup have after raising funds with a SAFE agreement?
The equity conversion trigger in a SAFE agreement is typically the startup’s issuance of preferred stock in a subsequent round of angel or venture capital funding. The startup may be able to structure a SAFE agreement that allows it to issue common stock to friends and family in an interim bridge fundraising round without triggering the SAFE conversion. This may not be as easy an option with convertible notes.
5. Will a startup need to commission a third-party valuation?
A SAFE agreement might require a company to commission a 409a valuation to establish a valuation and discount rate that satisfies tax regulations. Companies that issue warrants and options to employees face this obligation to comply with the tax code. 409a valuations can be expensive, and startups that need to commission them will also need to allocate resources away from developing their new products and ideas to pay for the valuation. There is currently no absolute obligation to commission a 409a valuation for SAFE agreements, but startups that have adopted employee stock option plans should consult with their legal and accounting teams to confirm that this will not be an issue for them.
6. How are valuation caps and discount rates factored into SAFE agreements and convertible notes?
Both types of instruments typically carry a discount rate that gives preferred stock to an investor at a discounted price over the equity price in the startup’s next financing round. Similarly, a very desirable startup may be able to negotiate either a SAFE agreement or a convertible note that does not include a valuation cap, although few investors will agree to omitting a cap.
7. What legal and administrative costs are associated with each option?
SAFE agreements are relatively simple and straightforward, and under appropriate conditions they can be drafted and closed with minimal costs. In contrast, the terms and conditions of convertible notes are often negotiated and the documentation for the debt instrument may go through several drafts, thus increasing the legal costs for convertible notes.
Convertible notes generally appeal to startups because of the greater amount of control that convertible notes give to entrepreneurs. Still, a growing number of startups can benefit from a SAFE fundraising strategy because of the simplicity and flexibility of that strategy. Venture Formations helps startups through the fundraising process. Please contact us for more information on whether convertible notes or SAFE agreements may be appropriate for your startup’s fundraising needs.