Raising capital for startups can often be tricky. Ironically, it usually costs quite a bit for startups to raise money in the initial rounds. They need to create elevator pitches, presentations, respond to information requests, and find the perfect angel investors or VC members to join the board. It’s not an easy task by any means!
Historically, the only way for founders to raise money was to offer convertible notes. There will be far more detail on these later on, but the general idea behind a convertible note is that it is a short-term debt that converts to equity later in the funding cycle (more often than not, this note comes “due” during the Series A round). As we’ll see, this type of investment type has its downsides, which is why Y Combinator invented SAFE notes. A SAFE note is a Simple Agreement for Future Equity.
Given the flexibility and power of SAFE notes, they’re generally the better option for new startups. Without any further ado, let’s explore what these investment types are, including the pros and cons, and why SAFE notes are typically the better option!
Table of Contents
- Convertible Notes: The Basics
- What Goes Into a Convertible Note?
- The Challenges of Convertible Notes
- SAFE Notes: What They Are and How They Address These Issues
- Other Important Notes on SAFE Notes
- Are There Any Cons of SAFE Notes?
- SAFE Notes vs. Convertible Notes: SAFE Notes Are Better
Convertible Notes: The Basics
Convertible notes are conceptually simple, yet they have quite a bit of subtle detail in their structure. The general premise behind a convertible note is that you will issue some dollar value of equity in the startup later in time, as repayment for the initial cash investment. So, instead of taking the cash investment now and giving them a percentage of the company right away, the startups provide investors with a promise to convert to equity at pre-agreed terms in the future.
If you’re reading about convertible notes for the first time, there might be a couple of questions running through your head.
First, why not issue shares right away? If the founders have 1,000,000 issuable shares in their company, why not say that the $100,000 investment equals 100,000 shares, for example? Founders can’t do that because they don’t know what the valuation of their company is and determining the value of a company that early on (when it’s often just an idea) is near impossible! If the company gets to Series A and those 1,000,000 shares have a combined value of $20,000,000 ($20 per share), that $100,000 investment now becomes $2,000,000 worth of equity. While that might be an excellent deal for the investor, it’s a lousy one for the founders.
Second, why not pay the investor money in return? Why convert to equity instead of taking that $100,000 investment and giving $110,000 back in the future? Startups often have limited cash on hand, and forcing the company to hit a deadline by which they could pay back their loan would be a hurdle that would be challenging for most startups to overcome.
What Goes Into a Convertible Note?
A convertible note has a few key parameters that both founders and investors alike should know.
- Valuation Cap: This number sets the maximum valuation at the time the note converts. It provides an incentive for investors with an equity upside if the startup gains value at a much higher rate than expected.
- Discount Rate: The discount the early investor receives relative to future investors.
- Interest rate: Since the invested money is technically a loan, it accrues interest. However, you won’t pay back the interest in cash, but instead in equity.
- Maturity date: The date by which the company must repay the debt.
To better grasp these concepts, let’s explore a simple example of a convertible note.
Let’s say Acme Inc., with 10,000 shares, takes a $100,000 investment at a 5% interest rate. The valuation cap is $1 million, and the discount is 25%. Further, suppose that Acme Inc. is a huge success. After one year, the Series A round begins, and Acme Inc. has a $2 million valuation. That amounts to $200 per share.
The convertible note comes due. Since there was a 5% interest rate, the total after one year would be $105,000.
With a discount and valuation cap specified, we need to compute, which would give the lower price per share (i.e., investors get one, but not both). The 25% discount would make the share price $150. However, the valuation cap method would be $100 per share ($1 million / 100,000 shares).
As such, the $100 price means that the investor takes 1,050 shares ($105,000 / $1,000,000 = 10.5% * 10,000 shares total = 1,050 shares).
At a real valuation of $2 million, the investor now has a $210,000 stake (1,050 shares * $200 per share). Practically, the investor doubled their money in a year.
The Challenges of Convertible Notes
In theory, these notes sound like a decent way to raise money. They’re relatively straightforward, and, although they can be nuanced, the rules of converting the investment into equity are very well defined. There’s a reason why convertible notes were one of the de facto ways for startups to raise money!
There are three big problems with convertible notes, though.
The first is that the giving away of equity in a future round means that, well, that future round has to happen! If the maturity date occurs before the next round of funding closes, the convertible note becomes a cash debt. Continuing with the previous example above, instead of converting $105,000 to equity, Acme Inc. would be responsible for paying out $105,000 cash.
For many companies, having to pay the original investment plus interest would be enough to push them towards bankruptcy!
Secondly, valuation caps and discounts can be double-edged swords. On the one hand, founders can use them to entice investors. That’s positive. Conversely, setting these values too aggressively, can hinder future funding rounds. When VC investors want to value the company at $10 million, and you had a future valuation of $1 million, it’s not going to be easy to reconcile that type of discrepancy.
Finally, there is no single standard “convertible note” out there. As such, convertible notes invariably involve lawyers. Even if you don’t have a lawyer the first time around, you’ll probably require them later if you end up modifying any of the terms. For example, if you need to extend the maturity date, you’ll probably need a lawyer to make that change and ensure the old contract is no longer “valid.”
SAFE Notes: What They Are and How They Address These Issues
Developed in 2013 by Y Combinator, Simple Agreement for Future Equity (SAFE) notes are significantly easier financing instruments. They take the best of what convertible notes have to offer, but they make them simpler.
SAFE notes are very similar to convertible notes, but they remove two problematic aspects for founders – the maturity date and the interest rate. Removing these two properties of the document makes these agreements and not a loan. Valuation cap, discount, and all the other aspects of convertible notes remain the same.
The result is a document that is approximately 5-6 pages in length. They’re so simple that Y Combinator makes them available for free on their website.
There are four different types of SAFE notes:
- Valuation cap included, discount excluded. Use this version when you want the investment to be subject to a valuation cap, but not have a discount option.
- Discount included, and valuation cap excluded. This version of the SAFE note eliminates the valuation cap but has a discount option.
- Valuation cap and discount included. This version is the most popular since it has two potential incentives for investors.
- No valuation cap or discount. Use this SAFE when you want to do a straight equity conversion later. Using this form is rare, however, since it provides no incentive for the investor.
Going back to why convertible notes are a problem, SAFE notes solve all but one of them.
Since the SAFE note is not a debt instrument, there is no maturity date. The lack of maturity date means that companies won’t fear going bankrupt because seed investments plus interest become magically due someday.
Similarly, because the SAFE notes that Y Combinator shares are incredibly simple and have a no-modification clause built into the contract, you often don’t need lawyers. Everyone knows what is in the document. All you need to do is fill out the valuation cap, discount, and investment amount, and you’re good to go.
Other Important Notes on SAFE Notes
There are a few other essential things to know about SAFE notes.
A SAFE note allows for “high resolution fundraising.” With this fundraising technique, instead of waiting for investors to close, you can enter into a SAFE agreement once both parties sign. The flexibility of signing a deal fast is one additional reason why companies are starting to use SAFE notes.
The current SAFE documents are “post-money” SAFEs, which means that all calculations finalize after the SAFE money starts arriving. The post-money SAFE also enables founders to calculate how much of the company they gave away.
SAFE notes also protect the equity in the business for as long as possible. Without a maturity date, there isn’t necessarily a time by the contract expires, and the money needs repayment. Therefore, SAFE notes let people protect the equity in their company.
Finally, investors and startups have embraced SAFE notes with gusto, so these agreements are prevalent among startup circles. Using one of these agreements will make investors happy to deal with you because they have probably seen it many times before.
Are There Any Cons of SAFE Notes?
Yes, as with any standardized contract, there are some downsides to using the SAFE.
Recall that convertible notes are debt instruments, and SAFE notes are merely promises of future equity in exchange for investment now. It’s a minor difference with one fairly substantial implementation detail. Any corporate entity can hold convertible notes. After all, if no conversion happens in the future, it becomes a loan.
However, SAFE notes have no such provision. This lack of a requirement means that, unlike convertible notes which are on the books as a future debt, SAFE notes are on the capitalization table like stock options (which is what they are).
The only corporate entity types with stock are C and S corporations. LLCs, which count the members as equal owners, do not have equity.
It’s a small hurdle, overall, to incorporate and have your startup be a full-blown company. However, it is one barrier to using SAFE Notes, mostly since early-stage LLCs generally prefer this corporation type’s simplicity and ease.
The other downside is more “human error” than the SAFE note’s fault, but many entrepreneurs don’t do the math quite correctly on the capitalization table. As such, when they get to the next rounds, they have far less equity than anticipated. Seeing their equity drop during a funding round from 80%, for example, to 35%, is highly demoralizing. When issuing SAFE notes, ensure that you don’t wind up giving away more of the company than you should!
Conclusion: SAFE Notes vs. Convertible Notes
Most people in entrepreneurial circles these days believe that SAFE notes are better. They’re simpler, easier, and don’t have the same level of cumbersome rules that convertible notes have. Plus, the fact that Y Combinator provides links to the four documents is astounding. It cuts down on legal fees significantly, which is a welcome relief for entrepreneurs and investors alike.
Ultimately, no matter which type of equity conversion document you elect to use, the important thing is that the founders and investors are happy with the result. To this end, make sure that any SAFE notes that you do offer won’t result in a significant diminishment of equity later on for the founders. It would be very challenging to watch as your ownership dropped from 75%, for example, to 35%.
If you’re unfamiliar with SAFE notes, you may wish to discuss them with other people to ensure that you have the capitalization table math firmly in your grasp to structure your notes well. Other than that, though, the flexibility and ease of SAFE notes far outweigh any downside. Therefore, SAFE notes are the way to go for most startups!
About the Author
Jonathan Hung is one of the most active angel investors in Southern California, his mission is to drive value creation within each portfolio company. In support of this mission, he serves as Co-Managing Partner at – Unicorn Venture Partners.
Jonathan and his team target investments in US companies that have global market potential with a focus on long-term growth expansion to East Asian markets.
Jonathan developed his investing prowess as a Managing Member for his family office fund, J Heart Ventures, which made investments in start-up companies such as Gyft, ChowNow, Miso Robotics, Clover Health, Bitmain, to name a few startups he funded.
Jonathan has various degrees from the University of Southern California, London School of Economics, Massachusetts Institute of Technology, and The Wharton School at the University of Pennsylvania.