In the early stages of fundraising, startup founders often need to pull in as much friends and family, angel, and seed stage funding as they need to survive and grow.
When startups raise money, they usually do so by issuing one or more classes of shares with special financial and control rights and benefits to investors. However, an ‘equity round’ (where a company issues shares to investors) can easily take many weeks or even months to complete and can easily cost $15,000-$25,000 or more in legal bills due to all the work required.
For very early-stage companies, taking that much time and money to do an investment round is just not an option -- early-stage companies want to raise money as quickly, easily, and cheaply as possible. Investors would also prefer that founders concentrate on growth and use as much money as they need to achieve traction instead of spending it on legal fees. As a result, most startups turn to Convertible Notes or SAFEs instead to meet their critical capital needs as quickly, inexpensively, and with as little hassle as possible.
In this article, we cover a few of the basics that about Convertible Notes and SAFEs you should know including how these two financing tools are the same and how they are different.
What is a Convertible Note and How Does it Work:
A convertible note is an investment vehicle that makes it easier for founders to raise money and investors back startups at an early stage, without the need for lots of expensive legal paperwork. It include the usual key financial incentives for investors to back them, such as a “cap” and/or “discount”.
However, a convertible note accrues interest and comes with a maturity date, and therefore needs to be paid in the same way as a loan until or if it converts into equity during a large enough funding round, depending on the terms of the convertible note. With a convertible note, investors know they will get the same shares, with all the same rights, benefits, and protections, that later, bigger investors, will insist on.
With a convertible note, investors are secure in knowing that they have the right to get repaid like any other creditor if there is no conversion in the future.
What’s a SAFE?
A SAFE is a convertible security that doesn't count as a debt. Unlike a convertible note, a SAFE doesn't include an interest rate or a maturity date. In a future funding round, a SAFE would be converted into equity, when you go through a funding round whereby equity is issued.
Similarities and differences: Convertible Note vs SAFE?
There are a few differences between convertible notes and SAFEs.
Anyone who holds a convertible note is a creditor like any other. Therefore, these convertible notes go on the books in the same way as other debts, and need paying every month in the same way.
Whereas, a SAFE is a contractual agreement. An investor is paying funds into a young company now, in exchange for equity at a future date. A SAFE, therefore, is not a debt and in most cases would not accrue interest; compared to convertible notes that almost always carry monthly interest payments on the capital invested.
Most convertible notes also include a maturity date whereby the capital most be paid back if there hasn't been a conversion to equity at that point in time. SAFEs don't come with that same time pressure, making convertible notes a slightly higher risk option for first-time founders. SAFEs also take less time to complete, from a legal perspective, making them more attractive for investors and founders who are keen to focus on growth and operational implementation.
In both cases, lending money to a very early-stage startup is a very high risk investment and, in most cases, if something goes wrong with the startup, an investor will never receive a penny back. Given that risk, there are a number of investors who don’t mind foregoing the advantages of doing their investment in the legal form of a loan just to keep the investment process as quick and simple as possible.
If, therefore, a startup does achieve sufficient growth to achieve a large enough equity funding round, early-stage investors know they will receive the same benefits and protections of later investors, often with extra incentives and protections, based on what was agreed when negotiating the terms of a SAFE or Convertible Notes.
Disclaimer: This article constitutes attorney advertising. Prior results do not guarantee a similar outcome. MGLS publishes this article for information purposes only. Nothing within is intended as legal advice.