December 23

SAFE vs Convertible Notes. Which is for you?

Kinetic

Here’s something I’ve been asked this past year. The following explanation and disclaimer serves two purposes (1) I can point my entrepreneurial colleagues to this post and (2) I can try to explain the concept clearly in writing.

What is a SAFE?
It’s a new financial instrument created by Y Combinator (the silicon valley accelerator). SAFE was created as a simple tool for seed investment that is purposefully designed to be easy to understand.

Essentially, a SAFE is a warrant to purchase stock in a future priced round. In contrast, a convertible note is debt that has the right to convert into equity when you hit an agreed upon milestone.

When evaluating which investment vehicle is best for you, you will definitely want to make sure that it aligns with your unique situation and your strategic goals. Let’s take a look the seven key variables that most founders use when negotiating a financing deal.

1. KISS:
Convertible notes can be complex. A SAFE is a 5-page document that was created for the purpose of simplicity. With that being one of the primary goals of its creators, it is the obvious choice for the K.I.S.S. model in that it doesn’t include an interest rate and doesn’t have a maturity date.

2. Conversion:
So both instruments allow for a conversion into equity. The difference here is that while a convertible note can allow for the conversion into the current round of stock, or a future financing event, a SAFE only allows for a conversion into the next round of financing.

Also, convertible notes typically trigger only when a “qualifying transaction takes place” (more than a minimum amount dictated on the agreement) or when both parties agree on the conversion. The SAFE can convert when any amount of equity investment is raised. This is nice for simplicity, but doesn’t give the control to the entrepreneur, which is why the convertible note appears to be the better choice in this category.

3. Discounts:
Both instruments carry a discount for the next round (or current round for convertible notes), so there is no clear advantage to either alternative here.

4. Valuation Cap:
Depending on your negotiating skills and your company’s traction, you can get a SAFE or convertible note without a valuation cap. However, it’s pretty difficult to do in this environment with either instrument, so there is no clear winner in this category.

5. Early Exits:
If you’re looking for an early exit, convertible notes and SAFE’s offer similar payout mechanism in the event of a change in control (acquisition/IPO) before a conversion can occur. The SAFE is written to give the investor the choice of a 1x payout or conversion into equity at the cap amount to participate in the buyout. In my experience, there are typically 2x payout provisions in most convertible debt agreements, which can still be written into SAFE agreements. Both alternatives have their advantages in this category.

6. Interest Rates:
SAFEs are not a debt instrument, instead, they are defined as a warrant. That means they do not carry an interest rate. Convertible debt, however, can carry a simple interest rate ranging from a 2% – 8% (most falling around 5%). Since most entrepreneurs don’t need another expense, a SAFE is the clear winner in this category.

7. Maturity Date:
Since a SAFE is not a debt instrument, it does not have a maturity date. Convertible notes have a maturity date, and this can cause some issues when the maturity date comes to pass. Once the maturity is reached, an entrepreneur has two choices: pay back the principle plus interest (if the company has enough money to do that), or convert the debt into equity. The latter is difficult to negotiate if the company isn’t doing well, and investors want their money back. It could even trigger a bankruptcy. Since that is the last thing an entrepreneur would like to deal with, the obvious choice from this perspective is the SAFE.

Other Considerations:
It’s debatable as to whether a SAFE would trigger the need for a fair valuation (409a), which could require funds be allocated towards professional services and not towards building your amazing product.

Another thing to consider is that raising common stock doesn’t trigger a conversion for a SAFE investor, so entrepreneurs in need of some extra cash could do a “friends and family round” and avoid the conversion trigger if there is a need to bridge.

The conclusion:
From an entrepreneur’s perspective, when weighing these variables, it’s pretty apparent that the SAFE is the most advantageous instrument for raising a seed investment. Why? Because it doesn’t require a maturity date, interest rate, or conversion (if you can hold out from raising a Preferred Series round). From our perspective, we believe that the SAFE is a fantastic tool for entrepreneurs to consider when they’re looking to raise their initial seed rounds.

Looking for more information on SAFE Financing? Check out this link on YCombinator’s website.

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