Every startup founder reaches that pivotal moment where their idea has gained enough traction that raising outside capital seems like the logical next step to accelerate growth. Whether or not this is your first rodeo as a startup founder, navigating the fundraising process can feel utterly bewildering.
Do you raise equity, take out a loan, crowdfund, or pursue some type of alternative financing?
At any given point, you will (or already have!) come across these two popular investment instruments: SAFE note and convertible note.
In this article, we will unpack the safe vs convertible note debate, explore their key differences and unique features so you can make an informed choice for your fund raising needs. Let's dive in!
What are safe notes and convertible notes
SAFE and convertible notes are two of the most common convertible securities used in startup fundraising. Both SAFEs and convertible notes allow founders to raise money from investors in a less complex way than traditional capital raising, and are often considered as "bridge rounds".
SAFE notes, short for Simple Agreement for Future Equity, have gained popularity in recent years due to their simplicity and straightforward nature. They are not debt instruments, they are agreements that convert to equity upon the occurrence of specific triggering events, like an IPO or a priced funding round.
In a SAFE note, the investor provides money to the startup in exchange for the promise of, as the term implies, future equity. The key word here is "promise" —the startup doesn't actually issue any shares or equity to the investor right away. Instead, the investor receives a piece of paper (or a digital document) that says they have the right to receive equity in the future.
Know more about SAFE note.
Convertible note, also called convertible promissory note, is a type of convertible debt that a startup can take out from an investor. Like SAFE, a convertible note allows the startup the option to delay the process of valuing their company until a later date. However, unlike a SAFE, a convertible note is an actual loan that the startup must pay back with interest.
The "convertible" part of the term refers to the fact that the loan can be converted into equity at a later date. This means that when the startup raises its next round of funding, the investor who provided the convertible note has the option to convert their loan into equity in the company. This can be beneficial for both parties—the startup gets to delay the process of valuing their company, while the investor gets the chance to turn their loan into equity and potentially make a profit.
Choosing between SAFE or convertible note comes down to the startup's unique circumstances, risk tolerance, and relationship with your investors.
Know more about convertible note.
SAFE vs convertible note: key differences
While SAFEs and convertible notes share some similarities, there are a few key differences founders should understand before deciding which one is right for their startup.
- Convertible notes usually have a predetermined valuation cap or conversion price, which determines the price at which the debt converts into equity during the next qualified financing round.
- SAFE notes typically do not have a predetermined valuation. Instead, they defer valuation until the next qualified equity financing round, at which point the investment amount converts into equity at the same terms as the new investors.
- Convertible notes may include a conversion discount, which allows the noteholders to convert their debt into equity at a lower price per share than the price offered to new investors in the subsequent financing round.
- SAFE notes may or may not include a discount rate. If included, it functions similarly to a convertible note's discount rate, providing investors with a lower price per share upon conversion.
- Convertible notes sometimes carry an annual interest rate, which accrues over the note's term. The interest adds to the convertible note's principal amount, and it is payable upon conversion or maturity.
- SAFE notes do not typically accrue interest. They are not convertible debt instruments so they do not carry an interest rate, which makes them more favorable for startups as it reduces financial burdens.
- Convertible notes have a maturity date, which is the deadline by which the note must be repaid or converted into equity. If the startup fails to raise a qualified financing round by the maturity date, the noteholders may demand repayment of the principal and any accrued interest.
- SAFE notes do not have a maturity date. There is no obligation for startups to repay the invested amount in cash if they do not undergo a qualified financing round. The investment either converts into equity or remains outstanding until converted or repaid through other means.
- Convertible notes convert into equity when triggered by a future financing event, in which a certain amount of capital is raised. The conversion may also be triggered by other events specified in the convertible note terms, such as a change of control or IPO.
- SAFE notes convert into equity when triggered by a future equity financing round.
When to use a SAFE note
SAFE notes are ideal for early-stage startups looking for a simple and quick fundraising option. Joshua Ismin shares their experience raising a SAFE round, and how fast it came together:
I was surprised at how quickly a round came together using SAFEs. I had this vision and I'm going to have to do a priced round. Using SAFEs and Cake, it just created momentum so much quicker. Using SAFEs in conjunction with Cake, it's like I've had a tougher time getting RSVPs to in-person events than getting investors to sign on because it just like made the process, templated and quick and, and, and sort of seamless. Once everything was set, it just, it just went so smoothly.
—Joshua Ismin, Co-founder & CEO at Psylo
SAFE notes are suitable for the following scenarios:
- Early-stage startups. SAFE notes are often favored by very early-stage startups that are still in the seed or pre-seed stage. They provide a straightforward and founder-friendly way to raise capital without getting into complex negotiations over valuation.
- Uncertain valuation. If the startup's valuation is uncertain or difficult to determine, using a SAFE note can be advantageous. Since SAFE notes defer valuation until a future financing round, both founders and investors can avoid setting a specific valuation at the early stage.
- Founder-friendly terms. SAFE notes are typically more founder-friendly, as they do not carry interest rate or have maturity date, making them less financially burdensome to founders compared to convertible notes.
- Streamlined fundraising process. SAFE notes have standardized terms, which can expedite the fundraising process and reduce legal costs, making them an attractive option for startups looking to close funding rounds quickly.
- Long-term funding strategy. If the startup plans to raise additional rounds of funding and prefers to defer valuation discussions until it has achieved significant growth milestones, SAFE notes can be a suitable choice.
Ultimately, the choice between SAFE notes and convertible notes should align with the startup's fundraising goals, long-term strategy, and the dynamics of the investment ecosystem. Startups should consult with legal and financial advisors to assess which instrument best fits their specific needs and investor expectations.
The Cake app comes built-in with SAFE note agreement template that you can use as is, or customize with inputs from your lawyer. Setting up a SAFE note raise is easy. You just need to provide your terms (raise goal, valuation cap, and discount rate) and a standard SAFE note agreement will be generated for you.
When to use a convertible note
Convertible notes are ideal for startups who are looking for a bridge round before pursuing a future price round. Here at Cake, we had a first hand experience raising through convertible notes, and can vouch for the benefits they provide.
A convertible note worked well for Cake as we were able to obtain early funding which allowed us to build and grow, while avoiding the delays and complications of a valuation. It still offered a financial return to investors via the 30% discount to the priced round. With the Convertible Note funding we progressed the company to achieve milestones that allowed a priced equity Seed Round.
—Jason Atkins, President & Co-founder at Cake Equity
Convertible notes are suitable for the following scenarios:
- Established startups. Convertible notes may be more appropriate for startups that have achieved some level of traction, have a clearer path to valuation, and have an understanding of their market position.
- Negotiated terms. If the startup and investors wish to negotiate specific terms, such as conversion discounts, interest rates, or valuation caps, a convertible note may be more suitable, as they offer more flexibility in customization.
- Short-term financing. If the startup needs short-term financing and intends to repay the debt if a qualified financing round is not achieved by the maturity date, a convertible note may be preferred due to its maturity feature.
- Investor preference. Some investors may have a preference for convertible notes due to their familiarity and the security provided by fixed valuation cap or discounts.
- Specific exit scenarios. If the startup anticipates certain exit scenarios, such as an acquisition or IPO, where having a fixed valuation is beneficial, a convertible note may be more appropriate.
Likewise, Cake has a standard convertible note template that's free to use as is, or customized for your needs. Approved by lawyers and used by many startup founders, a convertible note agreement automatically generates when you set up a convertible note raise. Sign up to get started.
Tax implications: how SAFE and convertible notes are treated
When it comes to raising funds for a startup, founders have to consider the tax implications of different funding options. While SAFEs and convertible notes share some similarities, there are also key differences in how they're treated for tax purposes.
SAFE note tax treatment
As earlier discussed, SAFE notes are not considered debt. They represent the right to purchase equity in a future priced round at a discounted price. No interest is paid on SAFE notes so there is no tax deduction for the company or interest income for investors.
However, when SAFE notes convert to equity, investors may be eligible for capital gains treatment on any profits made through the sale of equity. Capital gains are often taxed at lower rates than ordinary income.
Convertible note tax treatment
On the other hand, convertible notes are debt instruments, which means the company is obligated to repay the principal amount plus interest. The interest paid on convertible notes is tax deductible for the company.
However, interest paid to investors is taxed as ordinary income. Convertible notes can be advantageous for investors in high tax brackets looking to generate interest income. For companies, the interest deduction provides a tax benefit but also reduces cash on hand.
In summary, convertible notes provide interest deductions for startups but reduce available cash, while interest payments to investors are taxed as income. SAFE notes don't impact a startup's cash flow but investors may benefit from lower capital gains taxes down the road.
Founders should weigh these tax implications, in addition to other factors like valuation caps and investor preferences, when determining the best path to raising a seed round. The optimal choice depends on both the startup's priorities and the types of investors they aim to attract.
Simplify your SAFE or convertible note raise
The process of issuing SAFE or convertible notes have a lot of moving parts and can get overwhelming, specially for early stage startups. From setting them up, to keeping track of discount rates, valuation caps, or conversion triggers, to managing and communicating with investors and writing up note agreements.
Whether you want to use SAFE notes or convertible notes, Cake simplifies the process with its best practice SAFE agreement template and convertible note agreement template that you can use as-is or customized to your needs.
You can keep track of your notes in the Notes Registry, allowing you to easily view fully diluted shares and be notified of upcoming events (such as maturity dates). Investors can also keep track of their convertible note investment here too, giving them transparency and confidence in their investments.
How SAFEs and convertible notes could impact your valuation
When raising capital through SAFE and convertible notes, the valuation of your startup can be impacted in different ways.
With convertible notes, the valuation is set when the note converts to equity, typically at the next priced round. The cap on the note essentially places a ceiling on the valuation at conversion. If the next round values the company at or below the cap, convertible noteholders will get equity at that valuation. If the next round values the company above the cap, note holders still convert at the cap valuation.
SAFEs, on the other hand, have more flexibility in how they can impact valuation. The SAFE can specify a valuation cap, like a convertible note, but it can also specify a discount on the next round valuation.
For example, a SAFE may give investors the right to equity at a 20% discount to the next round valuation. If the next round is $10 million, SAFE holders would get shares at an $8 million valuation.
Most favored nation
Some SAFEs also include a “most favored nation” clause which guarantees investors the best deal.
For example, if you issue multiple SAFEs with different terms, and the next round triggers conversion for one SAFE, the “most favored nation” clause ensures that all other SAFE holders will get at least as good a deal. This prevents situations where early investors get disadvantaged by later, larger raises.
Flexibility, uncertainty, dilution
A SAFE without a valuation cap or discount essentially gives investors equity at the next round valuation, whatever it may be. This allows for maximum flexibility but also the most uncertainty for founders and investors alike.
For startups, higher valuations at conversion mean less dilution, but valuations that are too high can make it difficult to raise follow-on rounds. For investors, higher valuations mean more potential upside, but valuations that are too high mean a higher chance of downrounds in the future which reduce returns.
In summary, the type of seed investment instrument you choose—whether SAFE or convertible note—and the specific provisions within that instrument can have a significant impact on your startup's valuation, especially at the critical next round of funding. Founders should consider their goals and risk tolerance, as well as investor interests, carefully when negotiating these details.
FAQs on SAFE vs convertible notes
Here are some of the most frequently asked questions about convertible notes vs SAFE notes:
Are SAFE notes safer than convertible notes?
SAFE notes and convertible notes both carry risks and advantages. SAFE notes are simpler and do not have interest or maturity date, making them founder-friendly. Convertible notes offer more protection to investors, as they come with anti-dilution provisions.
Can convertible notes convert into SAFE notes?
No, convertible notes cannot convert into SAFE notes. Both SAFE notes and convertible notes convert into equity upon specific triggering events, typically the next funding round.
What happens to SAFE or convertible notes if a startup fails before conversion?
In the unfortunate event of a startup failing before conversion, the terms of the investment instrument dictate how investors are treated. In most cases, convertible notes will rank higher than SAFE notes in the company's capital structure.
Which investment instrument is better for early-stage startups?
Early-stage startups without a set valuation and seeking a simple fundraising option may find SAFE notes more suitable. However, if a startup has a reasonable valuation and can agree on terms, convertible notes may be a better fit.
Do convertible notes always convert into equity?
Not necessarily. The conversion of convertible notes into equity depends on the occurrence of the predefined event, typically the next funding round. If such an event does not occur, the notes may remain as debt and require repayment.
Can startups raise capital using both SAFEs and convertible notes simultaneously?
Yes, startups can raise capital using both SAFEs and convertible notes simultaneously. Founders may choose different investment instruments based on the preferences and needs of individual investors.
What happens if there's no next financing round?
If a startup is acquired or goes out of business before the next financing round, note holders typically convert their investment into equity at that time based on factors like the acquisition price or the liquidation value of the assets. The exact conversion terms should be found in the note agreement. This helps protect investors by ensuring they have the opportunity to gain equity even without a future financing round.
At the end of the day, convertible notes and SAFE notes both have their pros and cons. Founders need to weigh the options carefully based on their own startup's priorities and values. The most important thing is getting the funding you need to take your vision to the next level, even if that means giving up a bit more ownership or control.
Just remember, fundraising is a milestone, not the finish line. Take the money, build something great, help people, and stay focused on the long game. The investors who believe in you now will be there to support you for the future rounds too if you can prove your startup's worth and potential. Choose wisely and good luck!
This article is designed and intended to provide general information in summary form on general topics. The material may not apply to all jurisdictions. The contents do not constitute legal, financial or tax advice. The contents is not intended to be a substitute for such advice and should not be relied upon as such. If you would like to chat with a lawyer, please get in touch and we can introduce you to one of our very friendly legal partners.