SAFE Note vs Convertible Note: All You Need to Know
You might have heard the terms SAFE note and convertible note in the context of investments. SAFE note or Simple Agreement for Future Equity is a type of instrument wherein the company shares or stocks are issued to the investor after a certain period. While a convertible note is a debt instrument that can be converted into shares of the company at a later date. But how do these instrument work? what are the benefits of these instruments? and how do they differ from each other? In this article, we will be looking at the basics, the working mechanism, and the comparison between a SAFE note and a convertible note.
SAFE note and convertible note
Before delving into the details, let’s first understand the basic terms used in both instruments. Equity refers to shares or stock of a company that gives the holders an ownership stake in the company. On the other hand, debt refers to money borrowed from a lender for a specific term and at an agreed interest rate. In a SAFE note, the investor is given the right to acquire equity in the future, while in a convertible note, the investor is allotted a debt instrument that can be converted into equity in the future.
What is a SAFE note?
A Simple Agreement for Future Equity (SAFE) is a contract between the company issuing the note and the investor, wherein the company agrees to issue a specific pre-agreed number of shares to the investor after a particular period. This is similar to stock options or warrants where the holder of the instrument has the right to purchase the underlying security after some time. Since the company is obliged to issue the shares after a certain period, the investor is assured that the company will have enough funds to pay for the shares. Thus, this instrument is more commonly used by startups to raise funds from investors.
How does a SAFE note work?
A SAFE note is created to satisfy the funding needs of a company in an up-front manner, without any instant dilution of ownership. The noteholder receives an agreed number of shares at a later date for an upfront amount paid to the company. In simple terms, the SAFE allows investors to purchase equity in the company at a later date. Typically, the investors will want to buy preferred stock shares at a future funding round that is led by other investors, upon the company’s being acquired, or when it files for an IPO. The SAFE note is therefore a substitute for an option to purchase shares at a later date, with the added benefit of being a legally binding agreement.
What is a convertible note?
A convertible note is a form of debt instrument that generates an advantage for the company over time, as it allows the company to convert the debt into equity in the future. The note converts into equity at the time of maturity, which is generally one year from issuance. This helps the company to raise funds at a lower rate i.e. instead of an interest rate and principal repayment, the company will issue equity at the time of maturity. This is beneficial to the company in the long run as it will reduce the risk of dilution.
How do convertible notes work?
A convertible note is a loan instrument in which the borrower (the company) is given an amount of money from the lender, usually the investor. To raise the upfront money, the company promises to pay back a part of the debt in the form of equity at a later date. Converting debt into equity is mostly done at the time of maturity, which is one year from the conversion date. The repayment of the principal amount as well as interest will be converted into equity at the time of maturity. As a result, the debt value is raised over time by converting the principal amount of the loan and interest into equity.
Benefits of a SAFE note
A SAFE note provides key advantages to the company in various aspects. Here are some of the benefits of a SAFE note:
- Lower risk – Since the company is obliged to pay out the issued shares at a later date, the company is secured against any dilution of ownership for some time. Thus, a SAFE note helps in minimizing the risk of dilution, however, only for a certain period.
- Ease of issuance – The issuance of a SAFE note is easy, which makes it more accessible to startups and companies. By drafting and signing a SAFE note, the company can raise funds without having to go through regulatory requirements.
- Flexibility – The SAFE note provides greater flexibility to the company. Unlike a convertible note, there is no maturity date specified in a SAFE note, which means the company has greater control over the time of maturity.
Benefits of a convertible note
Convertible notes provide certain advantages, some of which are:
- Effective and efficient – Technically, convertible notes do not sell actual share ownership, instead it is considered as a loan. Therefore, the possibility of an inaccurate firm valuation can be avoided by both the issuer and the investor.
- Voting rights – Investors in convertible notes do not have the same voting rights as common shareholders when it comes to voting on corporate matters. As a result, convertible notes are considered to be safer than equity investments.
- Easy documentation – From a legal perspective, convertible notes are easier to document and review. In this regard, the funding rounds can be closed faster since it does not require the same amount of time and effort as equity investments.
Convertible note vs equity
Now you have an idea of what is a convertible note and how it works, let us look at convertible notes vs equity. Well, equity investment in privately held companies involves an investor providing capital to the company in return for an ownership stake, whereas a convertible note is a loan agreement between the company and an investor. In terms of structure, a convertible note is converted into equity of a company only at the time of maturity, whereas an equity investment provides instant ownership of a company after the investment. In short, a convertible note is a loan, but an equity investment is an actual ownership stake.
SAFE note vs convertible note
Probably you are already familiar with SAFE notes and convertible notes. Now, the question is how SAFE notes and convertible notes are different from each other. These instruments are typically different in terms of structure, features, characteristics and other components. In general, a SAFE note is a contract between the company and an investor as a way to issue shares at a future date. Whereas, a convertible note is a loan agreement that helps a company raise funds from investors by converting debt into equity at a later date. In the following section, we will take a detailed look at the key distinguishing characteristics of SAFE notes as well as convertible notes.
SAFE notes and convertible notes important terms
To better understand the characteristics of SAFE notes and convertible notes, it is essential to be familiar with the terms that are used in these instruments. Below mentioned are the important terms and definitions used in these two instruments.
Key terms in SAFE Notes
- Discounts – Oftentimes, in a SAFE note, the future converted equity is entitled to a portion of the discount that typically ranges from 10% to 30%. It means that the investor can acquire shares at a relatively lower price. However, it depends on the terms and conditions of the note.
- Valuation cap – The valuation cap is another term in a SAFE note. A valuation cap is used to obtain a lower price per share than potential investors. In SAFE notes, “valuation caps” refer to the highest price, or “cap,” that may be used to determine the conversion price.
- Most-Favored Nation (MFN) – When there are several SAFE notes, under MFV, it requires the company to notify the first SAFE, including the terms for the succeeding note. In case of the SAFE holder believes that the second SAFE note’s terms are better than the terms of the first SAFE, it could give the notice to require that the company match the same terms.
- Pro-rata Rights – Pro-rata rights, also known as participation rights, which provide investors to invest additional funds to maintain their percentage of ownership stake during a future equity financing round.
Key terms in Convertible Notes
- Maturity date – A convertible note has a maturity date, which is the date that determines when the conversion of debt into equity occurs. The maturity date of a convertible note is usually one year after the note has been issued.
- Valuation cap – A valuation cap is the maximum amount that can be converted from debt into equity. It is usually mentioned in the terms and conditions of the convertible note. Thus it sets a cap on the maximum conversion.
- Interest rate – The interest rate on the convertible note is the amount paid in the form of equity at the time of conversion. As a result, the payment of the interest is controlled by equity issuance.
- Discounts – When the maturity period is completed and debt is converted into equity, a conversion discount can be applicable where the investor can acquire shares at a relatively lower price.
Difference between a SAFE note and a convertible note
The following table highlights the key difference between SAFE notes and convertible notes:
| Basis | SAFE Note | Convertible Note |
|---|---|---|
| Valuation | Valuing early-stage companies is usually difficult. SAFE notes provide a way of deferring valuations investors allow companies to wait until a later date when a proper valuation is available. | Similarly, convertible notes are structured to avoid an earlier valuation. It is much easier for early-stage companies to raise capital if the valuation is yet to be determined. |
| Interest rate | Since the SAFE note is not a debt instrument, there is no interest involved in it. As such, no interest rate and maturity date are applicable in a SAFE note. | Convertible notes are structured as a debt instrument and payments of interest may be applicable. These interest payments are made by issuing equity. The interest rate range from 2% to 8%. |
| Discounts and caps | Valuation caps and discounts are applied to ensure that the SAFE note holder gets a fair price for their investment. It helps the company to determine a range of acceptable prices. | Similarly, convertible notes often provide valuation caps and discounts for the investor. The conversion is typically based on a valuation cap and a discount. |
| Equity characteristics | Well, the terms preferred stock is usually negotiated, and thus, companies are often in a situation where they are obligated to agree on a certain set of terms and conditions. Convertible note - Convertible notes are similar to SAFE notes in terms of equity. | Convertible notes are similar to SAFE notes in terms of equity characteristics. Both parties can negotiate and agree on the terms and conditions of the equity. |
| Cost | The cost associated with documenting SAFEs is relatively low because of its simplicity and flexibility. | Convertible notes are also cost-efficient as compared to other forms of raising capital through equity investments. |
| Financing amount | In a SAFE note, the financing amount can easily be determined or adjusted as per the company's requirements. | Similarly, a convertible note allows for greater control in setting up the financing amount as per the requirements of the company. |
| Lending laws | SAFE notes are often used to avoid the extensive regulations of lending laws such as state-leading regulations. Hence, the use of a SAFE note is easier and more flexible. | Convertible notes are more compliant with lending laws because it is considered debt instrument. State lending laws may be applicable depending on the state. |
| Conversion event | A SAFE note is simple and can be converted into preferred stock automatically after the company’s next funding round. | Convertible notes, on the other hand, may be subject to a variety of conversion events. When the startup raises a specific sum of money or even when the conversion is agreed upon by both parties, the conversion event occurs. |
| Speed | SAFE notes are completed much quicker than convertible notes due to their streamlined and simple structure. | The conversion process of a convertible note is typically complicated as compared to a SAFE note and thus, it is relatively lengthy and time-consuming. |
| Investor risk | The lack of maturity date in SAFE notes results in high risk for the investor since their investment can be locked for an unknown period. | Convertible notes are considered low-risk instruments as compared to SAFE notes because they have a maturity date. |
What do investors prefer, a SAFE or a convertible note?
You might wonder what is the best option for investors, convertible note vs SAFE note? Well, it depends on personal preference, financial situation, requirements, and circumstances of the investor. SAFE notes are becoming more and more common, especially with tech firms. Some investors, however, would rather continue using convertible notes or conventional stock financing. As a result, investors must evaluate all options to determine the best choice for them.
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