(last updated June 2021)
Convertible notes and SAFEs are usually used as interim or bridge financing, when a company needs funds to tide itself over for a while but isn’t yet ready to do a full equity financing and set a valuation for that purpose. They are also shorter and easier (and cheaper) to negotiate than a full set of equity investment documents.
A convertible note is a loan from the investor to the company (the “note” is a promissory note), but it differs from a usual loan in that the note is “converted” into equity under certain circumstances, meaning that the investment is recharacterized so the investor holds stock or membership interests instead of being owed money. The usual event that triggers this conversion is when the company subsequently raises funds from investors in a priced equity offering.
A SAFE (or, Simple Agreement for Future Equity) is conceptually similar to a convertible note — the investor puts in funds, and usually it is later converted to equity — but it’s not a loan in the first instance. There is no interest rate, maturity date or any of the other features of a typical loan. The form SAFE documents are open source and are available here.
The type of investors who invest in either convertible notes or SAFEs are thinking, long term, that this is an equity investment. In other words, they are not primarily seeking a steady return on their money that a pure loan would provide; they are looking for the potentially unlimited gain that an equity investment can generate. So, the argument in favor of using a SAFE is that it better reflects the intention of both parties by not introducing debt concepts like interest. On the other hand, the fact that a convertible note has a particular maturity date helps investors by putting time pressure on the company to raise more capital, thereby converting the note, to avoid having to default on the note.
There are a few terms that need to be determined and drafted in convertible notes, but are conceptually not required for SAFEs:
- Interest rate – convertible notes bear interest while the amount is outstanding. If the interest isn’t repaid before conversion, the accrued interest is added to the principal when calculating the number of shares to be issued.
- Maturity date – convertible notes are due and payable if not previously converted or repaid by a particular date. SAFEs don’t have this feature unless it’s negotiated by the parties. Having such a date puts pressure on the company to complete the financing that causes conversion, as they typically don’t have the ability to repay the investor in full, having spent the invested cash.
- Repayment terms – convertible notes are generally not intended to be repaid over time like a normal loan, assuming it is done as a bridge to an equity offering, but there could be individually negotiated situations including prepayment by the company.
Convertible notes or SAFEs can be calculated based on pre-money or post-money valuation. Pre-money means that the value is assessed before the money being supplied by the note or SAFE investor, and post-money means the funds supplied by the investor are taken into account. Post-money calculation is more investor-friendly, because in practical terms it means that the investors will not be diluted by other investors who are investing in notes and SAFEs alongside them. The details of calculation can become quite intricate, as outlined here.
In the simplest form of convertible note or SAFE, conversion to equity is based on the valuation of the financing that causes the conversion. However, one investor-favorable term is to establish a valuation cap to be used in the conversion calculation. If, for example, the company and investor agreed to set a valuation cap at $5 million, and the company later did a financing that caused the conversion of the note or SAFE that was based on a company valuation of $10 million, the conversion would be based on the lower $5 million valuation cap amount. The result of using the lower valuation figure in this example would be that the investor would receive twice as many shares upon conversion. The rationale for a valuation cap is that the investor deserves to be rewarded for having invested early, taking more of a chance on the company before it knew there would be a successful equity offering.
Like a valuation cap, a discount is an investor-favorable provision that can be justified by the investor taking more of a risk by coming in early. If there is a discount, the conversion price used to calculate shares on conversion is lower than the price paid by the new investor in the offering that causes the conversion. For example, if the SAFE or convertible note provides for a 20% discount, and the offering that triggers conversion is done at $5.00/share, then the conversion price would be $4.00/share (20% less), which results in a greater number of shares issued to the note or SAFE investor than would have been the case without it. Discounts and valuation caps are not mutually exclusive: there can be either one of them, neither of them or both of them. If both of them apply, then the calculations are first made individually applying the discount and the valuation cap. Typically, the investor gets the calculation that is more favorable.
In a convertible note, the conversion provision will often provide that only an equity offering that raises more than a particular dollar amount will trigger the conversion. Without such a threshold perspective, it would be possible for the company to force the conversion by selling a small amount of stock. From the investor’s, having this threshold incentivizes the company to raise the full amount needed to meet its business goals, and if it cannot, the investor would prefer to remain as a creditor, which is a better position to be in with a company having cash issues. The form of SAFE does not have a qualifying offering provision, but it does say that the equity financing must be “bona fide” for capital raising purposes.
The SAFE or convertible note will have a provision that will, typically, seek to give the investor the benefit of having made an equity investment prior to the sale of the company, even though conversion hadn’t occurred. In the form of SAFE, upon a sale (there is a definition of “Liquidity Event”), the investor can choose whether to get its invested cash back, or there is a conversion into shares based on either the valuation cap price in the SAFE or the price paid by the buyer in the sale of the company. If the investor opts to be converted, the investor would then receive its share of the proceeds of the company sale based on the shares received on the conversion.
At some point, if the company issues multiple rounds of SAFEs or notes, and inevitably there are individually-negotiated terms, so they have different valuation caps, discounts, interest rates, maturity dates, etc., it becomes a bit of a calculation nightmare for the company to figure out who owns the company. Additionally, not having a “clean” capital structure can be an impediment to investment by a larger institutional investor or an acquisition. Accordingly, it’s advisable to treat SAFEs and notes as the “bridge” instruments that they are intended to be and focus on completing the full equity offering that will force conversion, even though that process is time-consuming and difficult.