Key Terms of Convertible Notes and SAFEs
SAFE and convertible notes are great choices accessible to startups needing pre-seed or seed capital. Startups use Convertible instruments to raise financing. Choosing the right one will depend on how well you grasp the Convertible and SAFE note terms and which suits your business better. Convertible notes and SAFEs are the same instruments, differing in interest gains and maturity dates. In this article, you’ll find definitions for SAFE and convertible notes, and we also discuss the benefits and the risks of using convertible and SAFE notes.
Terms of convertible notes and SAFE notes
Both SAFE notes and convertible notes were created to change into ownership shares. Almost all key terms of SAFE and convertible notes are similar with the key distinction being that SAFE notes have a fixed way of converting, while convertible notes have different ways to convert. SAFE. Here is detailed information on both Convertible note terms, and SAFE note terms.
What are convertible instruments?
Convertible notes, safe notes, and other similar instruments are the different forms of convertible instruments that seek funding with a promise of shares in the company at a later stage.
Convertible instruments have scheduled payments for specific amounts at regular intervals, and the contract sets out predetermined rules for their conversion.
What is a convertible note?
A convertible note is a type of convertible instrument in the form of debt that can be exchanged for equity shares later. Convertible notes are a debt-equity swap, and they function similarly to owning a certain amount, except the swapping of stock for cash. Therefore, entrepreneurs can offer a convertible note in exchange for funding when they have a business idea.
Like other types of debt, the holder of a convertible note should make a repayment if they keep it until maturity. A preferred funding round must occur before its maturity date, and stock conversion is only possible during this preferred round for convertible notes. If a preferred round doesn’t happen by the time the convertible note reaches maturity,the investor has the right to demand a return of the investment.
The mentioned case above of an investor demanding the money back is rare as the owner can negotiate an alternative deal during that period. This article will also define many additional convertible note terms in more depth.
What is a SAFE note?
A SAFE note or simple agreement for future equity is another convertible instrument. A SAFE note is an enforceable commitment to enable an investor to buy a certain quantity of shares at a certain price at a future date.
Unlike convertible notes, SAFE notes are not debt instruments. It does not have a maturity date, rate or interest. But, like convertible notes, many new businesses employ SAFE notes to get funding for their new project and eventually convert them into equity. To better understand, we will also discuss different SAFE note terms in this article.
How do SAFE and convertible notes work?
Convertible notes are debts that convert into equity. The SAFE note allows holders to acquire shares at a future equity financing event at a fixed and discounted price.
With SAFE notes, the investors will purchase the preferred stock or an initial public offering filed by the company. SAFE comes with a valuation cap that defines the maximum amount investors can pay for the preferred shares, irrespective of the valuation. It also establishes a discount rate on the price for future investors in an equity funding round.
A convertible note provides an interest-bearing debt to the new business. It allows the holder to convert their debt into preferred shares or collect a lump sum repayment on the note at maturity. An upcoming fundraising event’s valuation will determine how much the notes can convert into preferred shares later. As an added incentive for potential investors, the convertible note has a valuation cap and a discount.
The table below helps to understand better:
| Aspect | SAFE Notes | Convertible Notes |
|---|---|---|
| Type of Instrument | Investment contract | Debt instrument |
| Conversion Mechanism | Converts into preferred shares | Converts into preferred shares or repaid as debt |
| Conversion Trigger | Future equity financing, takeover, or IPO | Future equity financing or maturity of the note |
| Equity Conversion Price | Fixed price (potentially discounted) | Based on the valuation of the upcoming round |
| Valuation Cap | Conversion value is sets at a maximum | Yes, sets a maximum valuation for conversion |
| Discount Rate | Yes, offers a discount on future equity price | The discount is applied to future equity prices. |
| Repayment Option | N/A | Repayment of principal plus interest at maturity |
| Investor Protection | Shares acquired at the better of discount or cap | Shares acquired at a discount |
| Timing of Conversion | Upon specified events (future equity round, etc.) | Upon specified events or maturity of the note |
| Participation in Future Financing Rounds | No participation rights | Potential participation rights |
Benefits of using SAFE and convertible notes
SAFE and convertible notes come with their own set of benefits for both entrepreneurs and investors.
- Both SAFE and convertible notes offer benefits for entrepreneurs and investors.
- Businesses can secure capital without an upfront company valuation.
- Legal simplicity and minimal paperwork are advantages.
- SAFE note contracts are even simpler than convertible note contracts.
- Negotiations are deferred until valuation, saving time and money.
- SAFE notes have a standardized process, reducing variables for negotiation.
- Business owners have more flexibility with SAFE notes.
- Investors don’t accrue interest or receive principal repayments with SAFE notes; convertible notes promise regular interest payments.
Risks of using SAFE and convertible notes
Despite some attractive benefits of using SAFE and convertible notes, they both come with their own set of risks and challenges.
- The conversion to stock is contingent on the firm’s success, and investors are not guaranteed a certain return.
- SAFE is a relatively new financial tool with unknown long-term consequences for investors and business owners.
- Investors and attorneys use less working with SAFE notes because of their relative novelty and may be wary about employing them.
- Conduct a 409a valuation to determine your company stock’s fair market value (FMV) – an additional cost related to issuing SAFE and convertible notes.
- Convertible notes are subject to the specific agreement; investors may include several provisions that may impact the business’s growth and future development..
- The investors may dilute the company’s valuation if owners get fewer shares. If the investor receives many shares, they may start meddling with the business’s decision-making, which might lead to problems.
Key terms of SAFE and convertible notes
Now that you know the benefits and risks associated with SAFE and convertible notes,it’s also important to know Convertible note terms and SAFE note terms before deciding to use them. Let’s discuss them here.
- Principal – The amount of money that the investor provided to purchase the note. For instance, If a shareholder invested $50,000, then $50,000 would be the principal sum.
- Conversion Discount – An Investor receives a percentage of each share during the next funding round’s purchase price for each share. For instance, a convertible investor gave $50,000 with a 20% conversion discount, and the new equity shares cost $2.00 each. 20% off the share price is $1.60. They will receive 31,250 shares ($50,000/ $1.60).
- Valuation Cap – The valuation cap limits the equity value of convertible instruments in the fundraising cycle. This value limit applies independently of financing round valuation. It protects investors against excessive firm valuation growth.
- Valuation Cap Type – Pre and post-money are the two types of valuation caps. The main distinction between them is in the calculation of the exchange rate. The conversion price arrives when the valuation ceiling is divided by liquidity capitalization. Liquidity capitalization for post-money value caps accounts for the shares that will be issued upon conversion of the post-money instrument. Pre-money instruments have a lower capitalization, It does not account for the newly issued shares made upon conversion.
- Conversion Price – The conversion price determines the highest price per share for converting convertible notes or SAFE into capital stock during the financing’s conversion, regardless of the company’s agreed valuation with new equity investors.
- Cash Out Multiplier – If a liquidity event occurs before the convertible note or SAFE is terminated, the payoff to the investor will be multiplied. It is recommended that a multiplier of 1x be used if no multiplier is provided when making a cash withdrawal.
- Liquidity – In case of a liquidity event, the SAFEs’ payout priorities are laid forth in the liquidation priority section. For post-money SAFEs, the priority in the liquidation clause specifies whether the SAFE ranks equally with preferred in the case of a liquidity event. Priority in liquidation must be senior to preferred unless otherwise specified in the agreement.
- Conversion Trigger – Convertible instruments may include provisions requiring the next equity round to meet a specified size threshold before conversion. If a hypothetical $50,000,000 conversion trigger on a SAFE or convertible happens. In this situation, the convertible instruments may only be exchanged for equity if the equity round is at least $50,000,000.
- Federal Exemption – Convertible Note terms and SAFE Note terms define all the federal exemptions that apply to the given convertible instruments.
- Interest Type – An option available through convertible note terms specifies interest will be calculated on a simple or compounded basis. The time frame during which interest is accrued and owed to the lender is known as the Interest Accrual Period. Choose “Daily” or “Weekly” if you want the interest to be expressed more often.
- Interest Compounding Period – As per convertible note terms, interest may be either simple, calculated or compound, calculated both on the loan’s principal and the preceding period’s accrued interest. Select either yearly, semiannually, monthly, quarterly, or every day.
- Interest Rate – One of the convertible note terms states the rate at which the note’s interest will accumulate each year. In a year, interest on a $20,000 loan at 6% would amount to $1200 ($20,000 multiplied by 6%).
- Interest Payout – Interest as per the convertible note terms may be paid in shares (if not cash) at subsequent funding rounds if the note’s holders agree to postpone interest payment.Your notes can have either a “Cash” or “Deferred” payment option.
- Maturity date – The holder must pay the full amount of convertible note at the Maturity date. If a note was issued on January 1, 2020, for ten years, its maturity date would be January 1, 2030. As per convertible note terms, the principal and accrued interest must be repaid if it has not been converted to equity before the maturity date.
- Change of Control Percent – A change in control before the maturity date may result in a premium or multiplier being imposed on the principal, and this may be specified in the Convertible Note terms or the SAFE Note terms.
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