Top Five Differences Between Convertible Notes and Safes for Founders

Authors: StartupPercolator

SAFEs and convertible debt financings broadly accomplish the same goals for early-stage (and even later-stage) emerging companies. The legal and negotiation costs of these instruments are typically an order of magnitude less than a traditional “equity” financing (Series Seed, Series A-Z, etc.), and for the most part they defer awkward, impractical or even impossible conversations about such issues as valuation, board seats, protective provisions, anti-dilution protections, rights of first refusal and co-sale, information and inspection rights to a later time.

Their general user-friendliness can be a double-edged sword, however, because without the advice of counsel, they can quickly get out of control, become hard to track, and prohibit or significantly hamper the Series Seed/Series A equity financing that they were initially meant to bridge toward.

But those are their similarities; this tip is about why two distinct forms of convertible securities exist in the first place if they are meant to accomplish the same overall goals.

1 (and 2). Interest and Maturity

SAFEs (SAFE is an acronym that stands for “simple agreement for future equity”) were created by Y Combinator in 2013 as an alternative to convertible notes. SAFEs were touted as superior because, since they are not debt (at least according to certain folks), they do not need to have things such as an interest rate and maturity date.

Convertible notes do have interest rates and maturity dates, but a properly structured convertible note round will have the notes become “demand” notes after maturity at the “demand” of the holders of the majority of the outstanding balance of all the relevant notes. And because most pre-equity investors tend to be friends, family or risk-tolerant angel investors, the maturity date is not as much of a doomsday clock as it may initially appear (of course, there are exceptions).

Similarly, any interest rate may seem objectively worse than not having an interest rate, but some investors may need to see some sort of interest, even if the rate is largely nominal, to justify their investment.

3. Structure

SAFEs are typically “stand-alone” but part of a “series” of otherwise identical SAFEs purchased by other investors at different times and for different amounts.

Convertible notes may be stand-alone or structured as a “series” of identical convertible notes, as SAFEs typically are, but the better and more typical structure is a singular parent “Note Purchase Agreement” (NPA) that contains most of the substantive terms of the financing and short “Demand Promissory Notes” issued to each investor as evidence of the date and amount of that investor’s investment.

A single governing NPA prevents accidentally issuing instruments with different discounts, valuation caps or other rights, because all of those terms are just housed in one agreement applicable to all investors (and yes, “SAFE Purchase Agreements” are possible, but they are not the norm).

4. Investor Familiarity/Tolerance

If an investor is willing to invest via a SAFE, the investor is almost certainly familiar and comfortable with a convertible debt financing. Conversely (especially outside Silicon Valley), if an investor is willing to invest in a convertible debt financing, it is not certain that the investor is comfortable or familiar with a SAFE. Accordingly, during a SAFE financing, a company may come across a potential material investor who will invest only through convertible debt.

5. Flexibility

SAFEs, because of their recency and the way they were introduced, are relatively standardized. Convertible notes/NPAs come in a much wider variety of formats. Both standardization and the availability of different formats can be good or bad. For SAFEs, certain terms (such as the “Pro Rata Rights Agreement” language, which requires that the SAFE holder be granted pro rata participation rights in future equity financings after they convert into equity) are investor-friendly and hard to remove since a savvy investor will compare a customized SAFE against the publicly available Y Combinator form. No centralized institution has issued a generally accepted model “form” of an NPA/convertible note financing, so if a potential investor (incorrectly) insists that it’s normal for a convertible debt financing to be secured by using the company’s assets as collateral, it is more difficult to point to a generally accepted standard to prove them wrong.

To wrap this up, the choice of whether to go with a SAFE financing or a convertible note financing is important, but only in the details. It is much more important to follow basic capitalization table principles (the ratio of the amount to be raised to the valuation cap, if any, for example). But understanding the pros and cons of each of the two most common types of convertible financings will help you understand why both continue to be commonly used.

How to Prepare for an Equity Financing

We have covered in past FTTWs how to value your startup and how much capital to raise. Once your startup decides to pursue equity financing, you should start to prepare for the investor due diligence process. On the business side, you will need to prepare a business plan and should take steps such as obtaining management references, interviews and background reviews, customer/user references, technical/product reviews, financial statements and business model reviews.

What Every Startup Needs to Know

On Wednesday, June 26th, Perkins Coie’s Palo Alto office hosted the startupPerColator event, “What Every Startup Needs to Know.” Lowell Ness, a Perkins Coie partner in the Emerging Companies & Venture Capital (ECVC) practice, moderated a panel which included Herb Stephens of NueHealth, Thomas Huot of VantagePoint Capital, Jennifer Jones of Jennifer Jones and Partners, Yuri Rabinovich of Start-up Monthly, and Olga Rodstein of Shutterfly.