The thriving startup culture in the USA has led to better financing schemes for the companies and helps them attract investors without putting too much at risk on their end. Simple Agreement for Future Equity (SAFE) and convertible notes are two such investment options popular among startups and investors.
Both work on the same principle where the investment is converted into equity as per the terms and conditions of the agreement. However, there is a stark difference between the two and the benefits they bring to the table.
So, let’s take an in-depth look into Simple Agreement for Future Equity (SAFE) and convertible notes and what makes them different.
What Are Convertible Notes?
Convertible notes are loans sanctioned by investors to start-ups in their growing stages, which can later be utilized to acquire company shares.
For example, when an investor finances a company, they generally take a portion of its shares. However, when startups receive funding through convertible notes, they do not have to transfer the company’s share instantly. Instead, the investor waits and lets the company grow and might ask for their shares or get their investment cash out later.
Convertible notes allow holders the right to receive equity in the company if specific circumstances occur, such as:
- A future equity financing (also known as Next Equity Financing or Qualified Financing), which a venture capital firm usually manages
- The company is being sold
- The notes’ maturity level
What is a Simple Agreement for Future Equity (SAFE)?
A Simple Agreement for Future Equity (SAFE) acts as an agreement between the company and the investor that gives the investor a right to purchase the company’s shares in the future in return for their funding.
A SAFE contract between a startup and an investor gives the investor the right to receive equity in the company in the event of certain triggering events, such as:
- Future equity financing (also known as Next Equity Financing or Qualified Financing), is usually led by an institutional venture capital (VC) fund
- The company is being sold
However, the price per share for sale is not discussed. The investor can only exercise these rights when a liquidity or investment round occurs in the future.
SAFEs vs. Convertible Notes: What Is the Difference?
SAFEs just give the investor the right to purchase shares. In contrast, convertible notes are a debt instrument that automatically marks a certain portion of the company’s equity for its future claim. Apart from this, there are five significant differences between SAFEs and convertible notes.
1. Conversion to Stock Options
The most significant difference between SAFE and convertible notes is the point of conversion to stocks. In the case of SAFEs, conversion is only triggered during a future fundraising event. This does not apply to regular financing events associated with raising common stocks.
On the other hand, for convertible notes, a conversion only takes place when:
- The parties agree to a conversion
- A transaction higher than the mutually decided transaction in the agreement takes place.
Along with that, a conversion can be triggered once the maturity date is crossed. This brings us to our next point of discussion.
2. Maturity Date
Simple Agreements for Future Equity do not come with a maturity date. For example, under a SAFE, the company receives investment during a funding round, and the investors gain the rights to buy the company’s stocks in a future equity round.
However, convertible notes come with a maturity date. By this date, the company either has to return the investment it received or convert the debt amount into company stocks and transfer it to the investor.
In that case, convertible notes tend to create urgency for owners, especially if the company is not churning enough profit. If things aren’t handled carefully, the company can face the consequences, depending on the investment value. That’s why it can be said, a lot of businesses prefer SAFEs over convertible notes.
3. Interest Rate
Since convertible notes are a debt instrument, the startup owners who have received the funding must pay interest to the investors. The interest rate varies within the range of 2% to 8% per annum.
On the other hand, SAFEs are not a type of loan or debt instrument. Hence, they do not come with any such additional liability.
Here again, SAFE offers a better solution for receiving funds than convertible notes. After all, when a company has just begun to take off, unwanted expenses like hefty interest can be a big hurdle.
4. Exit Strategy
Both Simple Agreements for Future Equity and convertible notes offer a payout option in case of an early exit. This usually occurs in the event of an acquisition or IPO.
For SAFE, the investor gets an option of 1x payout or to get their investment converted to equity at the cap amount, which further allows them to participate in the buyout. For convertible notes, the investor approximately receives a 2x payout.
When it comes to exit strategy, both these options provide an equally profitable and convenient way out.
Simple Agreements for Future Equity (SAFE) and convertible notes are competent options for getting adequate funding from the right investor. However, your current needs and vision for the company will decide which is a more suitable option for you.
Once you decide your next course of action, feel free to reach out to MSE experts and let them guide you from thereon. Then, finally, you focus on your business and let our specialist take care of the backend responsibilities of crafting and executing the perfect funding strategy.