Funding rounds or investments in privately held companies often raise whether the company should use a SAFE and convertible note or priced equity rounds. Each option has unique effects, demanding careful analysis. SAFE notes are popular among startups and similar to stock options, as convertible notes are debt instruments with the right to convert into shares, and priced rounds are equity investments in the form of shares.
This article provides a breakdown of the SAFE notes, convertible notes, and priced rounds to help you compare these funding instruments.
Convertible Instrument and Priced Equity Round
Before we analyze the differences between SAFE notes, convertible notes, and priced equity rounds, quickly review convertible instruments vs priced equity rounds. A convertible tool is any security that is convertible into another security at a specific price after a certain period or a particular event. Usually, convertible instruments are converted into company shares.
On the other hand, a priced equity round is an investment round in which the investors provide the capital to the company at a predetermined valuation based on an equity stake.
What is SAFE?
Simple Agreement for Future Equity (SAFE) is a method of raising capital in the form of equity. The investor can convert the SAFE note into company shares after a certain period, typically at the next round of preferred stock financing or a liquidation event.
SAFE note offers the investor the right to buy a specific number of shares of the company at a future date for a predetermined price. However, when it comes to convertible debt, there are long negotiations between the startup’s founders and investors. However, SAFEs (Simple Agreements for Future Equity) are distinct.
Y Combinator SAFE
The SAFE instrument highlights the “simplicity” of the transaction. SAFE was created by Y Combinator as an alternative to the convertible note, which was a form of debt for startups that carried interest payments. In other words, It is a contract in which Investors can support a startup by using promises to give them equity in the future. The agreement terms are simple, providing flexibility for investors and founders.
YC companies receive free credits or discounts on various services such as hosting, banking, cap table management, and back office. YC companies can access benefits worth over $500,000 thanks to our experience funding 4000 companies in the past 20 years.
How does SAFE work?
When a company raises funds through SAFE, the note holders assume no instant ownership rights. An investor provides funding to the company, and the company issues SAFE notes to the investor.
The investor can convert the SAFE note into shares of stock at a predetermined price after a certain period, usually after the next financing round
A SAFE note is the most common way companies raise capital from investors by using a deferred mechanism of issuing equity.
For a growing startup, the company is very likely to raise more money. So, this means that you will get the SAFE notes converted. The best option is to always consider a conversion way into the future since the risk is also high for investing in a startup.
Example For SAFE:
Let us take an example where Kelly invests about $30,000 in a company through a SAFE. The company will use this money to now build the business. But just to be clear, $30k isn’t a lot. So, once the company makes a bit of progress, they would want to raise more money. At this time, let us assume that the company has reached the value of $7M and they find an investor who agrees to invest $3M into the company. If 30% of the money is worth $3M after they invest, that means that the post-money valuation is $10M.
To get the ownership stake of this new investor, the formula would be: (new money/post-money) * 100% = ($3M/$10M) * 100% = 30% ownership stake.
Now, if we assume that the company had only 7M shares before the $3M financing, the price of the new share would be calculated as: pre-money valuation/pre-money fully diluted capitalization = ($7M/7M shares) = $1.00 per share. So, now that we have the price of the share, we can do the conversion of the $30K SAFE notes. And assuming that there is no discount and no valuation cap, the $30K SAFE will turn into 30,000 shares in the company.
From the table, it is clear that once the funding round had taken place, that is when the SAFE converted into shares. This means that Kelly, who was the initial investor in the business, ended up with 30K shares for the SAFE agreement she received.
What is a Convertible Note?
A convertible note is a form of debt instrument that can be converted into shares of the company at a predefined price, usually after a maturity date. The convertible note is often used as a way to raise capital from investors by private companies.
It is especially used by startups, as the company’s value is defined based on future predictions when seeking investment. As a result, debt can be converted into equity in conjunction with a future funding round. It usually includes several standard provisions, such as state lending laws and other clauses.
How Does a Convertible Note Work?
After a company receives funding from an investor, it issues convertible notes in exchange for the investment. The convertible note works based on whether the company undergoes a conversion event. If not, the convertible note operates like a regular debt instrument, with an interest rate and a maturity date
In the event of a conversion event, the entire principal amount of the Note plus any accrued interest will be converted into equity. The valuation cap or discount rate will establish the conversion price of the convertible note into equity.
Some convertible notes will include both a valuation cap and a discount rate. Generally, the note will convert at the lower of the two conversion options, which is good for investors. Calculating the convertible notes into share ownership of a company can be very confusing. But with the help of efficient tools you can make this complicated task easy. Calculating the convertible notes into share ownership of a company can be very confusing. That is where Eqvista can help with our convertible note calculator
What is a Priced Equity Round?
A priced equity round allows companies to raise capital through equity by providing a valuation to investors. A company must provide a valuation as part of the round, usually based on certain calculations, assumptions, and estimations. The investor and the company can negotiate the valuation prior to the funding round.
The investor is granted a certain number of shares based on the valuation and the amount of funds acquired. Unlike SAFE and convertible notes, in a priced equity round, the ownership stake is granted to the investor.
How does a priced equity round work?
Companies using a priced equity round raise capital by selling company shares to investors. The investors provide a certain number of shares based on the valuation set for the company and the amount invested by each investor.
At the same time, a priced round involves the negotiation between investors and the company, where the valuation is the key point of interest. The valuation is determined by hiring third-party valuations or relying on an investor’s assessments.
Pros and cons of a Convertible Instrument
SAFE notes and convertible notes have proven to be effective, however, these instruments have some disadvantages as well. Below mentioned are the pros and cons of convertible instruments:
- Efficient and affordable –SAFE and convertible notes give startups a means of raising capital quickly and at a reasonable cost. With fewer negotiations and limited legal fees, convertible instruments can be executed in a shorter time frame.
- Valuations are unnecessary -Convertible instruments are very flexible and can be converted into shares after the next financing round. As such, immediate valuations are not needed, which is beneficial, especially for early-stage startups.
- Straightforward process -Startups can easily structure and implement Convertible instruments. The process involves fewer legal forms, minimal paperwork, and quicker execution.
- Dilution for future funding rounds -Constant issuance of convertible instruments can lead to dilution of ownership in future fundraising rounds that harm the company’s valuation.
- Limiting other investment options – Convertible instruments can limit the number and type of future investment options. It can be difficult for startups to fund future rounds if they are dependent on convertible instruments.
Pros and cons of a Priced Equity Round
Priced equity rounds have their own benefits and drawbacks as well. The following are the pros and cons of a priced equity round:
- Clearly defined terms -A clear valuation and a set number of shares make the process more concise and less time-consuming. The guidelines for the round are well-stated, which prevents investor disputes.
- Attractive for investors – They expect instant ownership benefits when they provide funding. In addition, it offers a sense of security and protection as the ownership stake that granted immediately.
- Creates interest – The shares transfer immediately when the funding round is completed. Thus when investors become shareholders, they tend to be more interested and involved with the company.
- Time-consuming – Priced equity rounds involve a lot of time and effort. Even though there are certain advantages to using priced equity rounds, the lengthy process can be tedious and troublesome for startups.
- Higher costs – Priced equity rounds are more expensive to conduct than convertible instruments. The legal fees, valuation fees, and regulatory fees required can be costlier than those of convertible instruments.
Pros and cons of SAFE
A SAFE, or Simple Agreement for Future Equity, is a financial instrument commonly used in early-stage startup fundraising. Here are the pros and cons of using a SAFE:
- Simplicity: SAFEs are relatively straightforward compared to traditional equity financing. They don’t involve setting an initial valuation, which can simplify negotiations.
- Quick Execution: SAFEs can be executed quickly, which is valuable for startups in need of immediate funding.
- No Immediate Dilution: Unlike equity financing, SAFEs don’t result in immediate ownership dilution for founders and early investors.
- Flexible Terms: SAFEs can be adapted to suit the specific needs and preferences of both founders and investors.
- Conversion to Equity: SAFEs typically convert to equity (usually preferred stock) in a future financing round, aligning the interests of both parties.
- Incentivizing Early Investors: SAFEs often come with a discount on the future valuation, which rewards early investors for taking on higher risk.
- No Voting Rights: SAFEs do not grant investors voting rights or the ability to influence company decisions. This can be a downside for investors seeking an active role.
- Lack of Dividends: Investors do not receive dividends on their investment until conversion, which can make SAFEs less attractive to income-focused investors.
- Uncertainty: The lack of an initial valuation can lead to uncertainty about the ownership percentage investors will receive upon conversion.
- Tax Complexity: Tax treatment of SAFEs can be complex and may lead to unexpected tax liabilities for both founders and investors.
- Dilution upon Conversion: While SAFEs delay dilution, when they convert to equity in a future financing round, there can be significant dilution for existing shareholders.
- Not Suitable for All Startups: SAFEs are generally more suitable for high-growth startups with the potential for significant future financing rounds. They may not be ideal for businesses with different growth trajectories.
Key Differences Between SAFE, Convertible Note, and Price Equity Round
Now that we better understand each instrument, let us compare them to understand how each works on different levels. The following table depicts the key difference between SAFE, convertible note, and priced round:
|Basis of comparison||SAFE Notes||Convertible Notes||Price Equity Round|
|Interest Payable||No interest is payable when a company receives funding through a SAFE note.||A convertible note is an interest-paying instrument that requires the startup to pay equity interest.||Like the SAFE note, companies using a priced equity round do not have to pay interest.|
|Equity or Debt||Is neither a debt nor an equity.||Is a debt.||Not a debt. Direct exchange of money for preferred shares on an agreed price upon.|
|Flexibility||Complicated and less flexible.||Simple and straightforward.||More flexibility in various aspects such as valuation, offers, and equity stakes.|
|Valuation caps and discounts||The conversion of a SAFE note into equity takes place at a future date, so this is applied.||Valuation caps and discounts are applicable with a convertible note.||The equity value of a company using a priced equity round is not discounted or capped.|
|Deferred valuation||A SAFE note is only converted into a certain number of shares when a triggering event occurs, so the valuation is deferred.||A convertible note is deferred until the maturity date or the next funding round takes place.||The valuation of a price equity round is not deferred and is instead immediately calculated and implemented at the time of raising funds.|
|Cost||The costs associated with a SAFE note are relatively low.||Slightly more than that of a SAFE note.||Have higher costs than others due to legal fees, valuation fees, and regulatory fees.|
|Execution time||Can be executed in a relatively short time and is considered as the fastest instrument.||The execution time for convertible notes may vary.||The execution time of a price equity round is the slowest of all the instruments.|
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