By Fernando Berrocal

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How can startup founders determine whether to obtain capital from angel investors and pre-seed/seed VCs using a Simple Agreement for Future Equity (SAFE) or a convertible note?  In this blog, we'll cover which type of investment will best suit your startup's needs and help you get funding. First, it's important to understand why equity financing is rarely employed when a business is first getting started.

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Instead of using convertible notes or SAFEs, why can't entrepreneurs just issue equity to investors? Convertible financing instruments (convertible notes and SAFEs) exist for tax purposes and to reduce the risk of an IRS audit of a business and its founders. When an organization first starts, its common stock is essentially worthless, and the founders can acquire it for a little amount of money at par value at the moment of formation. If the startup turned around 3 months later and issued preferred shares to investors in a fundraising round for $2 per share, tax officials would be suspicious, and IRS inspectors might investigate. 

Convertible notes, which are effectively a loan or debt that must be paid back with cash before the maturity date or will convert into shares when the business raises a priced financing round, were invented by startup lawyers to avoid offering equity investment at a steep markup so soon after a company is incorporated.

SAFE provides Simplicity and Consistency: Convertible notes may be complicated and time-consuming. SAFEs, on the other hand, are 5 pages long and were developed primarily to streamline the seed investment process.  To design a convertible note deal or examine a note submitted to you by a potential investor, you'll almost always need to hire a lawyer. Most founders discover that they don't need to consult a lawyer when using a SAFE. The contract is basic, and it rarely changes.

Conversion into Equity with SAFEs and Convertible Notes: What's the Difference?  Both a SAFE and a convertible note allow for equity conversion. The main distinction is that SAFEs may only be converted into the organization's next round of preferred stock in the next priced equity round. Convertible notes, otherwise, can be converted into either the current round of shares or a future fundraising event in which a new series of preferred stock is issued.

Convertible notes also frequently contain conversion triggers, such as when a "qualifying transaction" occurs, the business is raising a certain amount of funds, or when both the company and the investor agree on the conversion. When you raise any amount of equity financing in a pricing round, the SAFE converts. This is neat and simple, but founders may find it less adaptable.

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Using SAFEs and Convertible Notes, Calculate the Valuation Cap and Dilution: Most startups that use a convertible note or a SAFE to get their initial funds from investors sign financing agreements that include a valuation cap. If your business has a lot of traction and you're a good negotiator, you might be able to get a SAFE or convertible note that is uncapped, which means it doesn't have a valuation cap. Convertible notes are frequently utilized by businesses to secure bridge funding in between equity financing rounds, without a cap, but at a discount of 10% to 20% (or even more) on the priced financing round that would follow soon after.

It's critical for a founder seeking funding using SAFEs or convertible notes to understand what's going on with their cap table and how much their ownership interest will be reduced. Although SAFEs are straightforward to utilize, entrepreneurs may wind up giving up more of their business than they intended by avoiding equity financing and offering preferred shares. Then, when it comes time to raise their first seed round or Series A, the dilution figures might be shocking.

Different Outcomes When Taking an Early Exit: Convertible notes and SAFEs have comparable payout methods when a change of control happens before conversion into preferred shares in the next pricing round if you choose to sell your business early. When an organization is bought, SAFEs provide noteholders the option of receiving a 1x dividend or having their notes converted into equity at the valuation cap. Convertible debt agreements, otherwise, have a wide range of payment clauses, with 2x payout provisions being the most common. Through the use of a side letter, these sorts of payment provision adjustments might be put into SAFE agreements.

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Interest Rates - Low vs. Zero: SAFEs are classified as guarantees rather than debt instruments. They don't have an interest rate or a maturity rate. Convertible notes, on the other hand, have an interest rate that typically falls between 2% - 8%, with the majority averaging around 5%. Many entrepreneurs favor SAFEs because, unlike convertible notes with an interest rate, the ownership stake an investor buys doesn't change depending on how long the SAFE is kept.

What Happens When Convertible Notes Reach Maturity Before a Priced Round? SAFEs do not have a maturity date because they are not debt instruments. Convertible notes are the way to go. This might generate problems for entrepreneurs if the maturity date passes before a pricing round is raised. The founders of a convertible note have three options when it "matures":

• Repay the principal as well as the interest (if the business has enough money to do that).
• Convert the debt into equity.
• With the investor, renegotiate the maturity date(s).

For a business that is not profitable and does not have the funds in the bank, repaying the principle might be tough. This might result in bankruptcy. Many entrepreneurs prefer SAFEs to convertible notes since SAFEs don't require repayment because they are not loans.

Ready to bring your startup to the next level? Apply to MassLight’s next batch. MassLight supplies capital and a dedicated tech team. We take equity in return. Have questions? Refer to our FAQ page.

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