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Convertible Notes and SAFEs (Simple Agreement for Future Equity) are commonly used fund-raising methods for startups and high growth ventures, and often applied in raising more funds between priced equity rounds.

Convertible Notes and SAFEs can be an efficient funding tool for investing in startups. However they can also be complex and should be carefully considered from a number of angles (particularly from a tax perspective) before transacting.

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Convertible Notes and SAFEs - Which Should You Choose? | Fullstack

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Convertible Notes and SAFEs (Simple Agreement for Future Equity) are commonly used fund-raising methods for startups and high growth ventures, and often applied in raising more funds between priced equity rounds. Convertible Notes and SAFEs can be an efficient funding tool for investing in startups.

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You and the investors must then agree on how much investment capital (money) the company needs to achieve its next set of goals (called "the investment round" or "the round").

You and the investors must also agree how that investment capital will be provided - which investors will contribute what amount. If there's an investor that contributes the majority of the capital, or even a stake larger than any other investor, they are usually called "the lead investor" or "the lead" and they may expect to define many of the variables in the valuation and the terms of the investment such as how much equity should be set aside for compensating early employees, what sorts of decisions the founders can make without board approval, who gets a board seat, and crucially, whether any investors get any special rights to get their investment back in case of the company going bust or being acquired.

Negotiating all those variables can take a lot of time. The riskier the investment is perceived to be, the longer it can take. The less interest there is in the investment opportunity, the longer it will take. Meanwhile, the start-up might be struggling without sufficient cash for growth and supporting existing customers.

So, the tech start-up industry also uses two alternative forms of investment, called a 'convertible note' and a 'SAFE note'.

How convertible notes work

A convertible note ("con note" if you're cool) is simpler than a priced equity round mainly because it postpones the need to agree on a pre-money valuation of the company prior to investment. Instead of the start-up offering shares to the investors, it offers a convertible note, which is a loan to the company.

BlueChilli entrepreneur-in-residence Alan Jones Ben Williams Photography

The loan has a fixed term, and an interest rate that accrues over the term. The interest rate is negotiable, depending on how much the investors want to invest and how much you want their investment (there's usually a going market rate which will vary, so check around with other founders who've recently raised on a convertible note).

At the end of the term, the investors participating in the convertible note can choose whether they'd prefer to have their principal back plus interest, or whether they would rather the loan be converted to shares in the company ("equity"). There are usually terms in the convertible note which specify some instances in which the loan automatically converts to shares, such as the completion of a priced equity round or the sale of the company.

A convertible note also usually includes a "valuation cap" - a maximum valuation at which the investment made via the convertible note will convert into equity. This protects the investor against receiving only a minuscule amount of ownership in the company because the valuation of the future priced equity round gets set so high. Investors in the convertible note typically get converted at the lesser of: (a) the valuation of the next qualified priced round; or (b) the valuation cap.

To compensate the investors for making an unsecured loan to a high-risk tech start-up, it's common to offer a discount on the conversion from debt to equity when the convertible note converts. How much of a discount is again dependant on how much the investors want to invest and how much you want their investment and you should check with other founders who've recently raised.

You don't need to negotiate a pre-money valuation, the paperwork is usually shorter (meaning cheaper to do with your lawyer and accountant) and you don't always need to agree on the size of the round - some start-ups will hold a convertible note open for some time, banking cheques from investors as they come in.

Why convertible notes aren't always best

In the US, convertible notes are commonly used for pre-seed and seed investment rounds and are an established way of investing in start-ups. In Australia, convertible notes are used, but are less common, partly because we're just generally a bit behind the times, but more often because more Australian tech investors are new to investing in this sector and more conservative in making investment decisions.

Some Australian investors feel that convertible notes have more risk for them than a priced equity round because, until a priced equity round occurs, the investors don't have a valuation on the company and hence don't know how much of the company they own. Personally, I don't care how much of your company I own as long as I believe you can turn every dollar I invest into one hundred dollars.

In general, Australia sees less competition between investors, lower valuations at each round, and more time between rounds. Each of these tends to take a bit of heat out of the competition between investors, which tends to make Australian investors more likely to prefer priced equity rounds to con notes.

As a founder, you need to remember that your convertible note funds are a loan and hence a debt that needs to be repaid, and also a debt which needs to be accounted for in your fiduciary responsibilities to the company. For instance, you can't allow your start-up to trade while insolvent, which could happen if you forget to account for one or more convertible notes that have yet to convert to equity. Multiple convertible notes are quite complicated to account for correctly.

What is a SAFE note?

SAFE is in all-capitals because it's an acronym that stands for "simple agreement for future equity". "Simple" is a relative term meaning "simple if you're a lawyer" but a SAFE note does usually have fewer pages, fewer clauses and is simpler to grasp.

While convertible note is a debt, a SAFE note is not debt so while a convertible note includes an interest rate and maturity rate, a SAFE note doesn't.

Both SAFEs and convertible notes convert into equity in a future priced equity round; a convertible note may have more complexity to when/if/how it converts. Both SAFEs and convertible notes can have valuation caps, discounts, and "most-favoured-nations" clauses (an agreement to offer the SAFE note investor the same terms as future investors on subsequent investment rounds and/or the opportunity to pull their proceeds out first in the event of a sale or winding-up of the company).

But unlike convertible notes, some SAFE notes, particularly in the US, don't include a valuation cap, or a discount on conversion to equity. Whether your SAFE note does - or does not - depends upon how much you and your potential investors want to make the deal happen.

Generally speaking, SAFE notes mean less risk for the founder and more risk for the investor. In an accelerator like Y Combinator where angels are falling over each other to get in on a first round, and funding rounds are much closer together, SAFE notes can work. In Australia, where there's less competition between investors, less momentum and less FOMO, it's definitely harder to raise on a SAFE note than a convertible note, and harder to raise on a convertible note than on a priced equity round.

Disclaimer: I am not a lawyer or accountant and you should probably engage the services of an experienced instance of both those before proceeding with an investment round, unless you're OK with learning the hard way. You should also seek the advice of the mentors and alumni in your start-up accelerator program, that's what they're there for.
Alan Jones is entrepreneur-in-residence at BlueChilli, a start-up incubator based in Sydney.

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Priced equity vs convertibles notes vs SAFE notes: how to choose

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You and the investors must then agree on how much investment capital (money) the company needs to achieve its next set of goals (called "the investment round" or "the round"). You and the investors must also agree how that investment capital will be provided - which investors will contribute what amount.

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A SAFE is a Simple Agreement for Future Equity - a type of convertible note. Pursuant to a SAFE, the investor makes a cash investment in return for a right to acquire shares at a later date (usually on the occurrence of priced capital raising). The number of shares received by the investor is dependent on the amount of cash invested and the valuation used in the priced capital raising.

Unlike other forms of convertible note, a SAFE is not a debt instrument, meaning there is no need to agree on details such as interest rates and maturity dates. It also means the parties can delay valuing the company (until a future priced capital raising). An additional benefit of the tax equity status of a SAFE is that these instruments are an eligible investment for Early Stage Venture Capital Limited Partnerships, a typical vehicle for venture capital investment in Australia. As a result of these features, it is a simpler document for investors and companies, requiring only the negotiation of the valuation cap or discount rate (if applicable). We explain these concepts in more detail below.

A SAFE will also generally contain provisions for early exits and insolvency (in which case the investor may get the opportunity to be repaid).

Different types of SAFE
The terms of a SAFE generally vary on the following items:
1. Valuation Cap
A Valuation Cap refers to the maximum valuation at which the cash investment made will convert to shares. It is an investor-friendly provision as it protects the investor from receiving a smaller number of shares if the valuation of the company increases significantly.
For example, if a SAFE includes a valuation cap of $3m, and the company undertakes a priced capital raising at a $5m valuation, the SAFE will convert based on a $3m valuation.
2. Discount
A SAFE may also include a discount to the share price of the future capital raising. This is to recognise the risk the investor has taken by investing in an early-stage company and the fact that the investor has invested money without the security of a shareholders' agreement. Discounts are usually in the range of 10%-30% but may be more if the investor is providing other services or benefits to the company.
For example, if a SAFE provides for a discount of 30%, and the company undertakes a priced capital raising at $2.50 per share, the SAFE will convert using a share price of $2.50 x 70% (being $1.75 per share).
3. Maturity Date
Usually, a SAFE will not have a fixed term. This means it won't convert until there is a future priced capital raising (which may not happen at all).
Sometimes, a SAFE will have a maturity date. In these cases, if there hasn't been a future priced capital raising by the maturity date, the SAFE will convert at a pre-agreed valuation (ie, a valuation floor).

Things to look out for
1. There are some things to consider (both for investors and companies) when using a SAFE: As repayment is not generally required, there is a risk to investors that the SAFE never converts.
2. SAFE holders are not shareholders (until the SAFE converts) and consequently do not have usual shareholder rights. If the investor wants particular rights (for example to participate in future capital raisings or information rights), a separate agreement will need to be entered into.
3. As SAFE's are relatively new in the Australian market, there may be a lack of familiarity with the document and legal jargon used.
4. Dividends are not paid to SAFE holders.
5. No interest is accrued on investments, which may result in a lower return on long-term investments when compared to some debt-like convertible notes.
6. If the company issues a large number of SAFE's before a priced capital raising, there may be considerable dilution to existing shareholders once the SAFE's convert. Because the conversion depends on the price of the future capital raising, it can be trickier to accurately predict the amount of the dilution.

Valuation Cap: Uncapped

Discount: 50% discount. This means muru-D, on its $75,000 investment will receive $150,000 worth of shares. This effectively says our program value is worth $75,000. Normally investors getting discounts on SAFE's receive a 10-30% discount, because they are getting a deal for investing early. muru-D receives a higher discount because of the additional benefits the program provides (the 6 months of training, office space and an active alumni program afterwards). If you think our support and network are worth at least $75K then this is a good deal for your startup.

Conversion Triggers: The muru-D SAFE converts on a Qualifying Financing. This defined as raising at least $200,000 at a minimum value of $2,000,000 (post money).

Maturity Date: If the company hasn't undertaken a Qualifying Financing within 2 years of the muru-D program start date, the muru-D SAFE note will convert using a fall-back valuation of $2,000,000.
This means the muru-D SAFE will never convert at a valuation which is less than $2,000,000.

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A SAFE is a Simple Agreement for Future Equity - a type of convertible note. Pursuant to a SAFE, the investor makes a cash investment in return for a right to acquire shares at a later date (usually on the occurrence of priced capital raising).

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A SAFE may feel safer to founders but will feel less safe to Aussie investors. Photo by Jason Dent on Unsplash

The short answer is that you can raise investment with a SAFE note or convertible note in Australia, but you may find it harder to raise your round.

Here's the longer answer (nothing that this advice pertains to Australian tech start- ups in 2020, that the future may be different and that other markets-like San Francisco-definitely are different).

Priced equity rounds

In a priced equity round, you and the investors must first agree on a dollar figure amount for the value of the company (called "the pre-money valuation" or sometimes just "the pre-money" or "the pre").

You andthe investors must then agree on how much investment capital (money) the company needs to achieve its next set of goals (called "the investment round" or "the round").

You and the investors must also agree how that investment capital will be provided - which investors will contribute what amount. If there's an investor that contributes the majority of the capital, or even a stake larger than any other investor, they are usually called "the lead investor" or "the lead" and they may expect to define many of the variables in the valuation and the terms of the investment such as how much equity should be set aside for compensating early employees, what sorts of decisions the founders can make without board approval, who gets a board seat, and crucially, whether any investors get any special rights to get their investment back in case of the company going bust or being acquired.

Negotiating all those variables can take a lot of time. The riskier the investment is perceived to be, the longer it can take. The less interest there is in the investment opportunity, the longer it will take. Meanwhile, the startup might be struggling without sufficient cash for growth and supporting existing customers.

So, the tech startup industry also uses two alternative forms of investment, called a 'convertible note' and a 'SAFE note'.

How convertible notes work

A convertible note ("con note" if you're cool) is simpler than a priced equity round mainly because it postpones the need to agree on a pre-money valuation of the company prior to investment. Instead of the startup offering shares to the investors, it offers a convertible note, which is a loan to the company.

The loan has a fixed term, and an interest rate that accrues over the term. The interest rate is negotiable, depending on how much the investors want to invest and how much you want their investment (there's usually a going market rate which will vary, so check around with other founders who've recently raised on a convertible note).

At the end of the term, the investors participating in the convertible note can choose whether they'd prefer to have their principal back plus interest, or whether they would rather the loan be converted to shares in the company ("equity"). There are usually terms in the convertible note which specify some instances in which the loan automatically converts to shares, such as the completion of a priced equity round or the sale of the company.

A convertible note also usually includes a "valuation cap" - a maximum valuation at which the investment made via the convertible note will convert into equity. This protects the investor against receiving only a minuscule amount of ownership in the company because the valuation of the future priced equity round gets set so high. Investors in the convertible note typically get converted at the lesser of: (a) the valuation of the next qualified priced round; or (b) the valuation cap.

To compensate the investors for making an unsecured loan to a high-risk tech start- up, it's common to offer a discount on the conversion from debt to equity when the convertible note converts. How much of a discount is again dependant on how much the investors want to invest and how much you want their investment and you should check with other founders who've recently raised.

You don't need to negotiate a pre-money valuation, the paperwork is usually shorter (meaning cheaper to do with your lawyer and accountant) and you don't always need to agree on the size of the round - some startups will hold a convertible note open for some time, banking cheques from investors as they come in.

Why convertible notes aren't always a better way to raise

In the US, convertible notes are commonly used for pre-seed and seed investment rounds and are an established way of investing in startups. In Australia, convertible notes are used, but are less common, partly because we're just generally a bit behind the times, but more often because more Australian tech investors are new to investing in this sector and more conservative in making investment decisions.

Some Australian investors feel that convertible notes have more risk for them than a priced equity round because, until a priced equity round occurs, the investors don't have a valuation on the company and hence don't know how much of the company they own. Personally, I don't care how much of your company I own as long as I believe you can turn every dollar I invest into one hundred dollars. But I'm atypical.

In general, Australia sees less competition between investors, lower valuations at each round, and more time between rounds. Each of these tends to take a bit of heat out of the competition between investors, which tends to make Australian investors more likely to prefer priced equity rounds to con notes.

As a founder, you need to remember that your convertible note funds are a loan and hence a debt that needs to be repaid, and also a debt which needs to be accounted for in your fiduciary responsibilities to the company. For instance, you can't allow your startup to trade while insolvent, which could happen if you forget to account for one or more convertible notes that have yet to convert to equity. Multiple convertible notes are quite complicated to account for correctly.

What is a SAFE?

SAFE is in all-capitals because it's an acronym that stands for "simple agreement for future equity". "Simple" is a relative term meaning "simple if you're a lawyer" but a SAFE note usually does have fewer pages, fewer clauses and is simpler to comprehend.

While convertible note is a debt, a SAFE note is not debt: a convertible note includes an interest rate and maturity rate, a SAFE note doesn't.

Both SAFEs and convertible notes convert into equity in a future priced equity round; a convertible note may have more complexity to when/if/how it converts. Both SAFEs and convertible notes can have valuation caps, discounts, and "most-favoured-nations" clauses (an agreement to offer the SAFE note investor the same terms as future investors on subsequent investment rounds and/or the opportunity to pull their proceeds out first in the event of a sale or winding-up of the company).

But unlike convertible notes, some SAFE notes, particularly in the US, don't include a valuation cap, or a discount on conversion to equity. Whether your SAFE note does - or does not - depends upon how much you and your potential investors want to make the deal happen.

Generally speaking, SAFE notes mean less risk for the founder and more risk for the investor.

So in an accelerator like Y Combinator where angels are falling over each other to get in on a first round, and funding rounds are much closer together, SAFE notes can work. In Australia, where there's less competition between investors, less momentum and less FOMO, it's definitely harder to raise on a SAFE than a convertible note, and harder to raise on a convertible note than on a priced equity round.
Disclaimer: I am not a lawyer or accountant and you should probably engage the services of an experienced instance of both those before proceeding with an investment round, unless you're OK with learning the hard way. You should also seek the advice of the mentors and other founders you know who've gone there before you.

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What's a SAFE, what's a convertible note, and are they really better than just selling shares to...

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The short answer is that you can raise investment with a SAFE note or convertible note in Australia, but you may find it harder to raise your round. Here's the longer answer (nothing that this advice pertains to Australian tech start- ups in 2020, that the future may be different and that other markets-like San Francisco-definitely are different).

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The shortcomings of SAFE notes (simple agreement for future equity) are coming home to roost; ironically, entrepreneurs are paying the price. Y Combinator invented the notes with a noble goal: "we intend the SAFE to remain fair to both investors and founders." But many SAFE notes that entrepreneurs are quick to issue now have a nasty bite: much more dilution than the issuers thought when they signed those documents.

Since the SAFE was created in 2013, many optimistic entrepreneurs have flocked to raise successive "mini-equity-rounds" using the SAFE format or traditional convertible notes. Little thought is given to the potential impact of these notes on future valuation, and their dilution implications are often overlooked. This can be especially appealing when raising individually small checks from unsophisticated angel and seed investors. And it can be a poisonous recipe.

We have observed the following in our own recent direct experience investing in SAFE and convertible notes: that many founders have a tendency to associate the valuation cap on a note with the future floor for an equity round; that they further assume that any note discount implies the minimum premium for the next equity round; and that many founders don't do the basic dilution math associated with what happens to their personal ownership stakes when these notes actually convert into equity.

By kicking the valuation can down the road, often multiple times, a hangover effect develops: Entrepreneurs who don't do the capitalization table math end up owning less of their company's equity than they thought they did. And when an equity round is inevitably priced, entrepreneurs don't like the founder dilution numbers at all. But they can't blame the VC, they can't blame the angels, so that means they can only blame... oops!

How did this happen and what does it mean?

While there are proper uses of notes (to bridge the company to achieve a major milestone, or driven by insiders' willingness to extend runway), there also are troubling and frequent improper uses (to postpone pricing equity until valuation is higher or to ignore the implicit message associated with being unable to find a lead investor to price the round on terms that the founders like).

Why is this troubling? Because it has become more common for VC funds to pass on investing in deals altogether, solely because the waterfall of notes would consume too much equity. If outstanding notes prevent a new lead investor from meeting their fund's required ownership targets without triggering a complete company recapitalization, a null set of equity distribution possibilities may arise.

It is critically important that VCs understand cap table math; unfortunately, many do not.

Some takeaways: It is critically important that VCs understand cap table math; unfortunately, many do not. Similarly, many CEOs don't realize the impact that multiple SAFE notes at various valuation caps have on the capitalization table and how these notes can negatively impact the financial viability of the company moving forward.

At its core, this issue points to the lack of understanding about the importance of post-money valuation by both entrepreneurs and investors. While VC deals remain marketed on a pre-money basis, sophisticated investors know that what matters most is the post-money (how much of the company will I own after all of the new shares have been issued). Unfortunately, what the CEO/founder forgets most often is that the notes have a multiplier effect in the post-money calculation; the more notes and the further the cap is from the new priced equity, the greater the variance between actual and nominal pre- and post-money valuations.

SAFE notes gone awry create undue negotiating tension between CEOs/founders and new investors, especially if this interaction occurs during the first priced equity round, because it is truly the first time founders and other common stockholders see the dilution in real terms. What often gets overlooked by founding teams when SAFE or convertible notes are issued is that a majority of the dilution has already occurred, by issuing notes. When the CEO sees his or her ownership fall from 78 percent to 35 percent in one fell swoop, they often assume and blame the new financing structure or the price. This may actually be a self-inflicted wound.

Some solutions

It is rare that a company begins marketing a first institutional-priced equity round alongside a converting note with a pro-forma "as converted" cap table in-hand. A proactive CEO should have company counsel prepare a pro-forma cap table of the company before issuing any notes, so the impact is fully understood before a note investment is ever accepted.

Issuer and investor awareness is key to minimizing the negative impact.

In more traditional convertible debt, it is possible to provide for voluntary note conversion under specific circumstances. Maturity/conversion ahead of a new equity round can greatly dilute all existing shareholders, but also can get a new lead investor "over the hump." Multiple series of notes can create "dilution waterfalls" and hamper future priced rounds, as large portions of the pie have already been carved out to founders, converted note holders and Series A investors. In these cases, the only valuations that makes sense for a Series B lead investor force the dreaded "down round."

While "rocket ship" companies can overcome the structural issues of rolling notes, there are many more SAFE issuers than there are rocket ships.

Many CEOs do not understand the true cost of the future equity they are selling in a SAFE or convertible note instrument, especially in the all-too-frequent "waterfall" scenario. Companies should always gauge whether notes are setting up the company for success in a future round, or whether additional notes are suitable at the company's current stage of development. Issuer and investor awareness is key to minimizing the negative impact moving forward, and can help improve capital efficiency in venture capital for early-stage companies.

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Why SAFE notes are not safe for entrepreneurs

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The shortcomings of SAFE notes are coming home to roost; ironically, entrepreneurs are paying the price. Y Combinator invented the notes with a noble goal: "we intend the SAFE to remain fair to both investors and founders." But many SAFE notes that entrepreneurs are quick to issue now have a nasty ...

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Information about startup documents, including the safe (simple agreement for future equity).

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A SAFE note refers to Simple Agreement for Future Equity, which was created by an accelerator, Y Combinator. It is an innovative form of convertible security that enable small business like startups to raise capital while postponing valuation, which improves capital efficiency. Like an IOU agreement, the SAFE note represents a more flexible agreement between the investor and a company. In exchange for upfront money, the investor gains the contractual right to acquire shares in the company in the future.

Generally, SAFE notes have no maturity date and no interest rate. They can help avoid fundraising gridlocks; close funding rounds efficiently; offer higher discount rates to investors; and, avoid premature valuations. But many SAFEs also include a valuation cap or maximum valuation threshold. This cap enforces a maximum value to which the SAFE can convert.

Mutual Benefits of SAFE Note

SAFE Notes enable companies to move quickly because investors don't have to do much due diligence (since they aren't buying shares upfront). Thus, start-ups can acquire money fast, skip the traditional time-consuming processes, and give one document that sets out an agreement for the future. This right is subject to certain parameters set out in the SAFE. They are appealing for companies because they don't give rise to issues of insolvency nor do they have the potential complexity around alternate debt funding. Further, they do not attract the same scrutiny as equity.

Process of SAFE Note

First, the investor agrees to give upfront cash payment to the company in return for contractual right to convert that amount into shares at a later date. At a later date, usually the closing of a priced equity round or liquidity event, the investor can choose to receive their investment amount back or convert that value into shares. In the context of shares, there is an automatic conversion process. The investment amount or share value depends upon the initial cash payment amount and the share price of the priced equity round or liquidity event. Akin to convertible notes, the company will issue discounted shares to reward the investor for their early cash injection.

Important Considerations

Companies should proactively and fully understand the true cost/impact of issuing SAFE notes, before an investment is accepted. They should consider whether SAFE Notes are appropriate for future success or whether further notes are suitable for the current development stage. Issuer and investor awareness is essential for mitigating unwanted risk/impact.

Use this SAFE Note If:

What does this SAFE Note Cover?

Further Information:

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A SAFE note refers to Simple Agreement for Future Equity, which was created by an accelerator, Y Combinator. It is an innovative form of convertible security that enable small business like startups to raise capital while postponing valuation, which improves capital efficiency.

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Understanding SAFEs and Priced Equity Rounds by Kirsty Nathoo