Part of the life of a startup is the necessity of raising capital. It goes with the territory. Fundraising can be challenging, and one of the challenging aspects is the need to understand the various fundraising options. Two of the most popular methods of raising funds is through issuing (a) convertible notes and (b) simple agreements for future equity (“SAFE”s). Each of these address in a different way one of the hardest problems facing the startup’s founders – what is my business worth today? Or, as they say in the trade, what is my valuation?
Keep reading to learn more about these funding instruments and consult with an attorney to decide which tool is right for your business venture.
What is a convertible note?
Simply put, a convertible note is a debt instrument that can later convert into equity. When the company receives subsequent funding, the holder of that note may (or sometimes must) convert it into equity. That conversion may come at a discount to the subsequent financing and it may have some very complex conversion variations. Should the company fail to receive subsequent finding, the note holder has the right to be repaid under the terms of the instrument. Convertible notes are a good way to close a seed round of funding, but it is also important to note that having poorly structured convertible notes can be an error that stays with you for a long time. In fact, it can cost the founder a substantial chunk of hard-earned equity.
A convertible note requires a valuation of the company. How binding that valuation is will depend on how well you’ve negotiated the deal. But there is an alternative for those who are reluctant to embrace a valuation – the SAFE.
What is a SAFE?
A SAFE is a newer type of instrument that facilitates a way for investors to provide pre-seed or seed funding to early-stage companies. SAFEs were introduced by Y Combinator, a tech startup accelerator, in late 2013. Since their creation, the use of SAFEs has grown tremendously. Just a word of caution – despite its name, a SAFE in the hands of an uninformed founder is neither simple nor safe.
What does a SAFE do?
The goal of these agreements is to streamline and accelerate the negotiations typically involved in the investment process. Thus, SAFEs present a set of standard, pre-agreed terms to govern an investment. A SAFE certifies that in exchange for an investment, the startup issues to the investor the right to certain shares of the startup’s capital stock upon a specified future event, like a capital raise or a sale of the business, subject to certain terms and conditions.
In straightforward terms, SAFEs allow for startups to raise funds quickly since there is no need to convince anyone of the company’s value. Despite this, many SAFEs will project a future valuation for the protection of both the founders and the investors.
Investors exchange a degree of uncertainty for the potential of a successful investment. SAFEs do not have a maturity date. Thus, if the company never does a funding round, no repayment to the investor is required. SAFEs also do not accrue interest that will need to be repaid to the investor. SAFEs provide a degree of flexibility in the way the company raises capital.
Will my startup engage with these sorts of agreements?
Both convertible notes and SAFEs are highly attractive tools for startups to raise capital. They each have their own built-in efficiencies as well as dangers. Some startups will issue both SAFEs and convertible notes, depending upon the goals of the investors and the outlook for future funding.
At HJF Law, we have drafted and edited many instruments of this nature, helping startups launch their ideas into reality. We can do the same for you.