Convertible Notes and SAFEs: Compatibility and Investor Options
When raising capital for a startup, entrepreneurs and investors often face the decision between using SAFEs (Simple Agreement for Future Equity) and convertible notes. Both financial instruments serve as a bridge for investors to secure their investment before a definitive equity valuation. However, many wonder if these instruments are mutually exclusive and if the investor retains the decision to convert or not.
Commonality Between SAFE and Convertible Notes
SAFEs and convertible notes are two popular funding instruments that are often seen in the startup ecosystem. While they serve similar purposes, it is a common practice for companies to issue both instruments within the same fundraising round. SAFE agreements and convertible notes are mutually compatible, allowing multiple forms of investment in a single round. For instance, a company may simultaneously issue SAFEs with or without pre-money caps, along with convertible notes with or without conversion options.
The main feature of both instruments is their flexibility. A SAFE allows investors to secure a future equity stake while deferring valuation until a specific event, such as a subsequent funding round or an IPO. On the other hand, a convertible note is a form of debt that can convert to equity upon certain trigger events, such as the completion of a priced round. In this way, SAFE agreements and convertible notes can coexist and be issued in the same funding round without conflicting with each other.
Company Stack and Legal Considerations
Including both SAFE agreements and convertible notes in the same round can be complex and requires careful due diligence. When different funding instruments are stacked together, it is crucial to ensure that they do not contradict each other or create undefined or unforeseen results. Failure to do so can lead to disputes, misunderstandings, and long-term business risks. For this reason, it is highly recommended to consult with an experienced startup/venture finance lawyer to ensure the compatibility of these instruments.
Convertible Note Conversion vs. SAFE Agreements
Most convertible notes are designed to convert automatically to equity without the investor having a choice in the matter. This automatic conversion is often dictated by a predetermined trigger event, such as the completion of a priced round. However, it is also possible and not uncommon to give investors the option to convert or not, either individually or as a group, and with or without the company's consent. The decision to include such options depends on how the notes are written. Always seek legal advice to navigate this complex area.
Pricing and Structures of SAFE and Convertible Notes
When structuring a priced round, companies often choose from three main options, each with its own strategic advantages:
Convertible Note with a Pre-Money Cap and Discount Rate: This structure offers investors a lower equity stake if they choose to invest before the maturity date. The note will convert to equity based on a predetermined discount rate. SAFE with a Pre-Money Cap and Discount Rate: A SAFE with a pre-money cap provides investors a higher equity stake based on a fixed valuation cap, with a discount rate applied on conversion. SAFE with a Post-Money Cap and Discount Rate: This structure is similar to the SAFE with a pre-money cap, but the valuation is based on the post-money cap, offering investors more flexible terms.For convertible notes, there is typically an option for the investor to choose whether or not to convert to equity during trigger events. This optionality is a key differentiator from a SAFE. Unlike a SAFE, a convertible note is essentially a debt instrument with a maturity date and interest accrual.
It's important to note that the choice of which instrument to use, and which structure to adopt, is highly dependent on the valuation of the startup and the specific investment goals of both the company and the investor. Consulting with a financial advisor and a lawyer is crucial for making the best decision.
Understanding the nuances of SAFE agreements and convertible notes is essential for any entrepreneur or investor navigating the complexities of startup funding. By carefully considering the options and seeking professional advice, both parties can ensure a smoother and more successful fundraising process.