It doesn’t matter if you’re raising money for the first time, or a fundraising veteran: keeping track of every financial instrument can be difficult. When you approach investors, you need to know your stuff.
You’re likely familiar with the priced round, aka equity financing. In this form of funding, your company’s shares are assigned a dollar value, and you sell those shares to an investor in exchange for money. Upon completion of fundraising documents, the investor immediately becomes part owner of your company.
But what if you’re an early-stage company that’s not ready for a priced round? Perhaps you’ve got limited runway, you need capital quickly, and want to reach a few more company milestones before assigning value to your shares. During an economic downturn, venture capital funding tends to drop. With VC uncertainty looming in 2023 and beyond, many startups will be wary of selling shares at lower-than-normal valuations.
Convertible instruments – such as SAFEs and convertible notes —could give you extra time to grow your early-stage business before a formal equity financing round. A convertible instrument is a form of investment in which founders can receive capital from an investor while postponing negotiations on their startup's valuation. Investors give you money today, and you agree to set aside some shares for them when you do your next round of financing.
Let’s explore the SAFE vs. convertible note vs. priced round equation. Remember that SAFEs and convertible notes are very similar, with a few key differences. Keep reading, and you’ll find some helpful tips for startups and a tool to help during your fundraising process:
What is a SAFE?
SAFE stands for “Simple Agreement for Future Equity,” and it’s pretty self-explanatory.
Say an investor gives you $1 million in exchange for a SAFE. At your next priced round – whenever that is – you owe that investor $1 million in equity, with other deal terms often sprinkled in (more on that shortly).
A SAFE is considered a warrant, not a debt, meaning there’s no maturity date or fixed interest rate.
What is a convertible note?
A convertible note is a form of debt from an investor that can turn into equity upon some triggering event, such as a fundraising milestone, merger or acquisition.
The convertible note is similar to a loan, but instead of paying back interest in cash, you pay it back in shares. Because it’s a form of debt, the convertible note includes a maturity date and a fixed interest rate.
Once again, let’s say you receive $1 million from a VC in exchange for a convertible note. You’ll eventually owe your investor $1 million worth of shares, plus the interest accrued. However, you don’t owe anything until that triggering event, which is agreed upon by both parties.
If the triggering event hasn’t occurred before the maturity date, your startup owes your investor the principal, plus interest (usually between 2-8%). Both parties can agree to extend the maturity date if they choose.
SAFE vs. Convertible Note
The key difference in the SAFE vs. convertible note discussion: a SAFE is a warrant, whereas a convertible note is a form of debt.
SAFEs don’t accrue interest. However, SAFEs also afford you less flexibility, because you owe the shares to your investor immediately upon completing your next priced round.
With a convertible note, your triggering event might come later. You could agree to convert the note after you reach $10 million in funding. That could mean you go through multiple subsequent rounds before you have to pay your debt, as long as you haven’t raised $10 million.
SAFEs are best for companies trying to avoid maturity dates and extra fees from interest. Convertible notes afford you more flexibility on when your payment comes due — giving founders more cash on hand in the short term.
How do SAFEs and convertible notes work?
You might be thinking: why would investors be willing to wait for their equity?
Early investors — those that have taken a bigger risk —often receive more bang for their buck via the SAFE and convertible note. These three deal terms are important to incentivize investors to jump on board in the early stages – and can qualify for either type of convertible instrument:
A valuation cap is the maximum price at which you will convert the outside investment into equity. When you first agree to your SAFE or convertible note, you don’t set a share price (that’s the incentive for you).
Back to the example of a $1 million via SAFE or convertible note. Your investor might place a $5 million valuation cap on their investment. That’s to say, your investor gets their shares at a $5 million valuation upon the next round — even if you raise money with a new investor at say, a $10 million valuation.
Essentially, they get their shares at the pre-determined valuation cap (at a discount), regardless of anyone else’s actions. That’s their incentive for helping you out earlier.
The conversion discount affords your early investor a discount on the price per share in future rounds. Perhaps you’ve set a 20% conversion discount. At your next round, you might determine your shares are each worth $1. All new investors pay $1/share, but the investor with the SAFE or convertible note can buy shares at $0.80/share.
Investors could negotiate both a valuation cap and a conversion discount. However, they’ll usually only be able to use one of the two — whichever provides them with a lower share price.
Most Favored Nation Clause
This clause protects the investor, ensuring that they don’t miss out on a more favorable deal in the future. If another VC invests with better valuation caps or conversion discounts after the initial investment, the previous investors are allowed to amend their contract to match these more favorable terms.
What is a priced round?
A priced round, aka equity financing, involves selling shares of your company to an investor, after those shares are assigned a dollar value. Of course, the major difference here is that you aren’t able to postpone your startup valuation.
Priced rounds can be complex. Many equity financings take months to close, and startups often pay thousands in legal fees to execute the due diligence process. However, most of that time is dedicated to negotiating a term sheet, which can provide detailed guidelines and help avoid future misunderstandings and disagreements.
Additionally, lead investors are often more willing to provide advisory services and guidance to companies they’ve already closed a round with. Sometimes, priced rounds are worth the wait.
Deciding between SAFE vs. Convertible Note vs. Priced Round
In short, convertible instruments like SAFEs and convertible notes offer flexibility and control for early-stage startups that are still finding their way. These financial tools are attractive for founders that need capital quickly but aren’t quite ready to assign value to their shares.
SAFEs aren’t a form of debt, allowing founders to avoid maturity dates and interest fees – but your shares will be due upon your next round of funding. Convertible notes allow startup leaders to postpone the valuation conversation even longer, at the cost of owing debt and interest to your investor.
Both SAFEs and convertible notes are typically faster and more flexible than raising money via a priced round. The priced round, however, is highly-structured and provides startups with true investment partners.
The SAFE vs. convertible note vs. priced round conversation is different for every startup. No matter your situation, it’s important to be informed and organized before you come to the table with investors. Shoobx helps startups stay financing-ready by combining equity management, corporate governance, fundraising tools, and documentation into one collaborative platform.
Whether you’re looking to keep an accurate cap table, seeking a 409A valuation or building a term sheet, Shoobx helps you automate your financing activities. We’re here to help you scale efficiently and sustainably.Learn more about Shoobx’s startup solutions as you grow your business.