STARTUP FINANCING: SAFE vs. Convertible Notes. Part III.
Updated: Jun 28, 2020
Most startups need to raise money soon after formation in order to fund operations quickly and the Simple Agreement for Future Equity (the “SAFE”) or a convertible note can be a vehicle to fund early stage companies. Unlike the sale of equity in traditional priced rounds of financing, a company can issue a SAFE or a convertible note quickly and efficiently. What is the difference between the SAFE and a convertible note? Which one is better for a company and an investor?
The SAFE is an agreement that if a company raises money (or is sold or goes through an IPO), the investor will get company stock at a later date. Convertible notes are loans that (ideally) convert into stock if a company raises money (or is sold or goes through an IPO). The SAFE has become an alternative to convertible notes when a company is reluctant to issue debt for fear of reaching the maturity date before having raised money. The SAFE was created to avoid renegotiation when a company that has issued convertible debt reaches the maturity date, and the founders need to negotiate an extension with the noteholders (who may try to extract better terms in exchange for their consent). The lack of a maturity date therefore makes the SAFE a less investor-friendly instrument than convertible notes.
Similarities Between SAFEs and Convertible Notes.
The SAFE has many of the most important features of convertible notes, such as:
- Postponing company valuation,
- Conversion events, and
- Conversion prices.
More information about those and other provisions of convertible notes see Startup Financing: Convertible Notes. Part II.
Differences Between SAFEs and Convertible Notes.
The SAFE lacks the hallmark debt features that are found in convertible notes, such as:
- No debt priority in a liquidation (because the SAFE is not debt);
- No maturity date (the SAFE remains outstanding indefinitely); and
- No accruing interest (the SAFE converts into equity at a lower price per share than in the subsequent financing round based either on the discount or valuation cap).
Disadvantages of SAFEs for Investors
- Investors do not have a recourse if a company does not raise money; and
- The proper tax treatment of SAFEs is uncertain because of the combination of both debt and equity features (as explained above).
Using SAFEs instead of convertible notes benefits companies due to a lack of maturity date. For the same reason, most angels and venture capitalists will not invest in SAFEs.
When do you Need an Attorney?
When attempting to raise money, you may need an attorney to advise you on the different types and stages of startup funding, to evaluate deal terms, prepare the company for due diligence and, hopefully, draft and negotiate a term sheet and closing documents. You will also need an attorney to comply with securities laws because every security sold, including SAFEs and convertible notes, must either be registered with the Securities and Exchange Commission or exempt from registration. For more information about compliance with securities laws see Startup Funding: Sources and Rounds. Part I.
This article is not legal advice, and was written for general informational purposes only. If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author Kristina Subbotina. Ms. Subbotina is a New York-based attorney specializing in advising individual and corporate clients on aspects of corporate and securities laws.