With convertible notes slowly becoming a thing of the past, in recent years startups are beginning to embrace Simple Agreements for Future Equity (SAFE) as an alternative to raise funds. Despite being similar as both are tools for raising funds, there are many outstanding differences between them and we will dive deeper into them in this article.
What are Convertible Notes?
According to FundersClub, convertible notes are an investment that is structured similarly to a loan. A convertible note is a type of debt which might convert into equity in the future. Debt, I’m sure most of you out there are familiar with this term, if not put it simply — When I borrowed money from you, I have to pay you back in the future, but with interest. A convertible note is a type of debt but slightly different as instead of paying you back with interest in the near future, we change that into equity and offer you part of the ownership. Sometimes we like to call convertible note debt-like since it’s similar to debt with slight variations.
What is SAFE?
SAFE was introduced by the Silicon Valley accelerator Y Combinator as the new big boy in town for startups to have more options, or even to replace convertible notes when it comes to raising capital. To put it simply, SAFE is a warrant to purchase a stock at a later priced round, and hence is basically a contract. The main difference SAFE differs from convertible notes are maturity date, interest rate, and conversion to equity.
While SAFE is not a debt and hence does not have a maturity date, convertible notes do have a maturity date.
Upon reaching the maturity date, entrepreneurs face tough decisions on whether to pay back the principal of the convertible note, with interest or convert the debt into equity for the investors. Most would opt for the latter option as paying back the principal amount with interest could be difficult for startups, especially at an early stage.
As discussed earlier, since SAFE is not a debt, but a warrant/contract, it does not carry an interest rate hence keeping things simple and founder friendly. While SAFE does not carry an interest rate, convertible notes, on the other hand, carry an interest rate (simple and not compounded) between 5–8%.
For example, if the interest rate was 5% in a $100,000 convertible note seed financing and Series A funding round occur a year later, the investors would convert an additional $5000 ($100,000 x 0.05).
This may not be considered important for a short-term investment but may create financial problems if it’s long term and since there is maturity date for convertible notes, this might post as a bigger problem to entrepreneurs. The interest rate, however, could be a way to incentivize startups to raise rounds on a timely basis. That being said, there is a maximum interest rate that may be charged on a loan depending on which state, this is known as Usury Laws by State.
California for example (for obvious reasons), according to Law Office of Melissa C. Marsh, ” Pursuant to California law, non-exempt lenders (the average individual) can charge a maximum of: (i) 10% interest per year (.8333% per month) for money, goods or things used primarily for personal, family or household purposes and (ii) for other types of loans (home improvement, home purchase, business purposes, etc.), the greater of 10% interest per year, or 5% plus the Federal Reserve Bank of San Francisco’s discount rate on the 25th day of the month preceding the earlier of the date the loan is contracted for, or executed. In other words, the general rule is that a non-exempt lender cannot charge more than 10% per year (.8333% per month) unless there is an applicable exemption”.
Conversion to Equity
While both SAFE and convertible notes do offer a conversion into equity, there are differences since they do not call for the same terms of conversion.
SAFE only allows for conversion into equity at the next round of financing. Meaning, if you decided to opt for SAFE during the seed round, conversion into equity option is only available the following round, meaning Series A round. Hence SAFE does not carry a multitude of conversion events.
Speaking of which, I almost forgot to mention during the next funding round, SAFE can be converted even when you raise any amount of equity. Many have argued that SAFE is very easily manipulated because, without minimum amount raised to trigger conversion, you could simply raise $8000 the next round and trigger the conversion.
For convertible notes, besides allowing a conversion during maturity, it does have an option to convert at the current round, and future round. Also, a conversion would take place when the minimum amount (reflected on the agreement) is met.
For example, assuming investor invested $200,000 and were granted the right to convert to equity at a $2 million valuation. If the start-up were then acquired for $10million, the investor would receive $1 million or 10% of the proceeds, by converting the $200,000 loan into equity representing 10% of the issued and outstanding equity, post-conversion ($200,000 divided by $2 million + $200,000).
What’s the Best Option for Seed Investment?
So, after diving into the 3 main differences between SAFE and convertible notes, what does that mean for all entrepreneurs out there? For my take, SAFE is made simpler for entrepreneurs and they can use SAFE to raise capital with ease without having to go through the trouble of negotiating maturity date and interest rate terms, and also clarify when is the next funding so as to trigger the conversion. SAFE does indeed align the interest of investors and entrepreneurs in a whole new different way. That being said, always remember that what might be a pro to one start-up could be a con to another and hence depending on the nature of your start-up, choose wisely. Are you a startup seeking funding during Seed or Series A? Check us out here!
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