Make smarter decisions at the seed funding stage by learning about SAFE and convertible notes.
If you are looking for ways to raise funds for your startup, SAFE (simple agreement for future equity) and convertible notes are two options at your disposal. But what do these terms mean? And what do they look like in practice?
As an entrepreneur, it is important that you understand the options in front of you before you make a decision. With that in mind, let’s find out how SAFE and convertible notes work and the differences between the two to help you pick one that suits your funding needs.
What is SAFE financing?
SAFE was introduced as a concept by the U.S.-based startup accelerator company, Y Combinator, in 2013. SAFE refers to an investment contract between an investor and a startup that gives the investor the right to receive equity in the next round of equity financing (led by a venture capitalist firm) or the sale of a company.
What is a convertible note?
Convertible notes refer to debt securities issued by startups in exchange for capital. A convertible note provides an investor the right to collect on a company’s equity securities in the future or receive the principal with interest on their investment.
How are these two modes of financing different from each other?
|Points of comparison||SAFE||Convertible Note|
|Implementation||Simple to implement, typically never modified||need to go through a lawyer and have to be reviewed by investors.|
|Interest rate||Does not have an interest rate||Has an interest rate to help protect investors’ funds in case the company goes bust.|
|Maturity date||Does not have a maturity date since it is not a debt instrument.||Has a maturity date on which the startup needs to decide whether to pay back principal with interest back to the investor or convert it to equity.|
Just by looking at what the two terms mean, it’s hard to tell the difference between them. Both give investors rights to equity at some later point in time. However, in practice, these two terms have different implications.
One of the main differences between these two terms is that SAFE offers simplicity, whereas convertible notes are known to be pretty complex. In fact, Y Combinator came up with the idea of SAFE as an alternative to convertible notes. To issue a convertible note, you will first have to draft the agreement and consult with a lawyer. This agreement is then sent for review to the investor. SAFEs, in contrast, are just five pages long and typically never modified, thus helping founders close deals faster.
SAFE doesn’t carry an interest rate, but convertible notes do. Convertible notes are debt instruments. Thus, they have an interest rate to help investors safeguard their resources in case the company is shut down.
SAFE has no maturity date. SAFEs simply convert to equity in the next round of financing that the startup undergoes. For convertible notes, there is a maturity date on which the entrepreneur can either decide to pay back the principal investment with interest or convert it to equity.
Founders have, over time, found SAFE investments quicker to implement in the seed phase of the startup. However, you may still encounter investors who are only willing to invest using a convertible note. As a founder, you must make the choice between these two financing options based on the nature of your startup.
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