Startups need to raise money during the pre-seed and seed rounds of funding. However, many startups aren't formally valued during these funding rounds so it's difficult to come up with investment terms that work for both parties. In these cases, entrepreneurs and investors have two choices. Either convertible notes or SAFE notes.
Convertible notes benefit investors more because there's less flexibility in the deal and a maturity date. On the other hand, SAFE notes benefit entrepreneurs more because the terms are more flexible and the document is easier to understand.
That said, we're going to take you through everything you need to know about the differences between convertible notes and safe notes.
A convertible note is a type of convertible debt. Angel investors use convertible notes during the seed and pre-seed rounds of funding to invest in startups. Investors often prefer convertible notes because the terms are less flexible. Plus, there is a maturity date for the notes to become equity.
It's also important to note that convertible notes are also redeemable as debt. When startups don't have the capital or capability to provide equity, investors have more protection with convertible notes because the loan still needs to be paid back. Convertible notes also carry interest rates for these reasons.
Convertible notes are complex investment deals with several terms. The terms of each convertible note will vary but there are some basic principles that each convertible note includes.
We include these principles below.
Valuation cap: maximum valuation when the convertible note converts
Maturity date: when the convertible note is converted regardless of equity
Discount rates: A discount that an investor gets for investing early
Interest rates: The amount a startup needs to pay in equity, which is a little more than the principle of the "loan."
These are only some of the basic principles found in convertible notes. Depending on the company, principles will vary.
Convertible notes typically favor the investor. They favor the investor because of several general principles. First and foremost, convertible notes have a maturity date that's difficult for entrepreneurs to change or delay. Second, convertible notes have interest rates that help angel investors profit.
There are several benefits of convertible notes. Convertible notes will also benefit the investor and entrepreneur in several ways. Below we list several of the benefits of convertible notes.
Founders start growing the startup before worrying about paying off debt
Convertible notes bypass the lengthy process of issuing equity because it's technically debt instead
The terms lack flexibility, so founders don't need to worry about renegotiation as often
Less room for error when compared to SAFE notes
Less expensive than other types of loans or convertible debt
Depending on the type of startup you have, there may be more or fewer benefits. For example, tech startups benefit greatly from convertible notes because entrepreneurs have more time to focus on the technology.
Unfortunately, convertible notes have several drawbacks. Most of the drawbacks are drawbacks for founders because the terms of a convertible note are hard to change.
We take you through the disadvantages of convertible notes below.
If convertible notes don't convert the startup needs to repay the loan, which may lead to bankruptcy
Difficult to control convertible notes
More than one investor might get involved because convertible notes can be offered to more than one party; this causes conflict (sometimes)
Equity becomes diluted
These drawbacks pertain more to entrepreneurs than investors. In fact, many angel investors prefer convertible notes because of their drawbacks.
SAFE notes, also known as a simple agreement for future equity notes, are an alternative to convertible notes. With SAFE notes, a startup doesn't need to take on debt. Instead, SAFE notes agreements anticipate that investment amounts are unsecured. Therefore, investment amounts are drawn as lump sums.
It's also important to note that SAFE notes don't have maturity dates or interest rates. SAFE notes don't have these terms because it's not debt. For entrepreneurs, SAFE notes are more favorable during the pre-seed and seed rounds of funding.
SAFE notes have several terms you need to be aware of. These terms are similar to convertible notes but you'll notice a few key differences.
We'll take you through the common terms of a SAFE note below.
Valuation cap: highest permissible value for the company
Discount rates for shares: investors are granted a discount for pre-seed and seed round investments
Pro-rata rights: investors can invest more capital to maintain equity
Numerous convertible events
You'll notice that terms like "interest rates" and "debt" are missing. These terms are missing because SAFE notes are not a debt vehicle.
SAFE notes favor the founder more than the investor. These notes benefit entrepreneurs more because the terms don't include interest or debt. Without interest and debt, there's less pressure on entrepreneurs to pay back debts.
SAFE notes come with several key benefits. Many of these benefits favor entrepreneurs but angel investors also like SAFE notes because they're less complicated than convertible notes.
We'll take you through some of the benefits of SAFE Notes below.
SAFE notes are easier for accountants and bookkeepers to file
Compared to convertible notes, SAFE notes offer more flexibility
Fewer negations than convertible notes
Investors may convert their notes for equity in the company
Simple, straightforward, and easy to use
There are flexible terms for early exits, so startups have many methods to cash in on their equity
Startups and investors will also notice the unique benefits of SAFE Notes that are industry-dependent. So, it's important to consider all of your options.
SAFE notes are almost always better than convertible notes for startups. However, many angel investors prefer convertible notes because they offer more protection for their investments. In some cases, this takes SAFE notes off the table.
It's necessary to understand the limitations of SAFE notes, so we take you through each one below.
Risky investment for investors because there's no debt
Only corporations can use SAFE notes
Unique jargon that not many people understand – complex legal terminology
Fewer returns than convertible notes, especially when held for more than a year or two
Entrepreneurs lose equity in the company when they convert, which reduces ownership
Limited amount of specific SAFE notes
Some SAFE noted will trigger a fair valuation
While there are many drawbacks to SAFE notes, they're still the best option for startups (in most cases).
Choosing funding methods for startups and connecting with investors is never easy. You need to weigh the options of every investor and determine how much equity in the company you're willing to part with. While convertible notes and SAFE notes are similar, SAFE notes are better for startups.
SAFE notes are better for startups because there is no debt associated with the transaction. Ultimately, there's less pressure on startups when SAFE notes are used instead of convertible notes.
Convertible notes are the best investment vehicle for angel investors who invest in startups. SAFE notes work well for the startup but the deal removes pressure from entrepreneurs because there's no debt. Because there's no debt, SAFE notes lack interest rates or any protection for the investor. For this reason, convertible debt, which is a debt-based investment vehicle, is better for investors.
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