It has become increasingly common for Australian startups to raise capital through the use of convertible instruments. Two of these instruments are Simple Agreements for Future Equity (SAFE) and convertible notes. With these, an investor will provide you money upfront, and, in return, you commit to issuing them shares in your company when a specific event occurs. This article will compare SAFEs and convertible notes from a priced equity round before exploring the differentiating features between the two.
What is a SAFE?
When you enter into a SAFE, you receive capital upfront and provide your investor with the right to obtain shares in your company at a later time. Since you are not issuing shares, you do not need to place a valuation on your company. This is often a challenge for early-stage startups, particularly those in the pre-product and pre-revenue stages.
After a specific “trigger event”, you will have an obligation to convert your investor’s SAFE note into shares. The most common trigger is when you issue shares in connection with your future priced equity raise, which is known as “qualified financing”. To reward your investor for taking the risk of investing in your early-stage startup, the number of shares your SAFE investor will receive at the trigger event will be based on either a:
- discount to the share price paid by the investors at your priced equity raise; or
- valuation cap, whereby the share price is calculated using a pre-determined company valuation.
What is a Convertible Note?
When you issue convertible notes in your company, you are issuing an instrument that is a hybrid between a SAFE and a loan. Unlike SAFEs, convertible notes contain a maturity date and, commonly, an interest component.
Additionally, in comparison to a SAFE, where you typically have no obligation to issue shares until a future-priced equity raise, a convertible note requires either conversion of the investment into shares or repayment at the end of the set term with interest.
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The primary consideration an investor will make when looking to enter into a SAFE or convertible note is your future capital raising plans. If you do not have any future plans to raise capital through a priced equity raise, an investor may be reluctant to invest in your startup using these instruments.
Conversion Events
Convertible instruments contain “trigger” events that result in either conversion into shares or repayment in cash. The main trigger events include:
- a future-priced equity raise;
- listing on a public exchange;
- selling your business or business assets; and
- an insolvency event.
A significant point of difference between SAFEs and convertible notes is that convertible notes contain an additional trigger event, by way of an expiry date (maturity). At maturity, your investor’s convertible notes convert into shares or become redeemable in cash.
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Investor Rights
With both SAFEs and convertible notes, your investor does not become a shareholder until a trigger event occurs. In a priced equity raise, when the investor pays for their shares, they become a shareholder and gain the rights associated with shareholders once the round closes. Therefore, in a priced round, the investor’s rights and obligations are contained in both their subscription agreements as well as your shareholders agreement.
Key Differences Between Capital Raising Instruments
| SAFE | Convertible Note | Subscription Agreement | |
| Negotiation | Usually, the quickest and most cost-effective option with the least negotiations. | Typically, additional negotiations compared to a SAFE due to the added complexities associated with the interest and maturity mechanisms. | This will depend on the investor. Generally, negotiations become more complex and timely based on the amount and type of investor. |
| Term | No. It is uncommon to see a maturity date in a SAFE. | Yes. It is common for convertible notes to contain a maturity date, which is a time-based conversion mechanism. | No. You will not have any requirement to repay the investor. |
| Discount | Yes. | Common. | N/A |
| Valuation Cap | Yes. It is commonplace for SAFEs to include a valuation cap, but it is not required. | Yes. It is common for convertible notes to include a valuation cap, but is not required. | N/A |
| Interest | No. It is highly uncommon to see an interest rate in a SAFE. | Very often included but not strictly required. | N/A |
| Documentation | SAFE Agreement only. | You will require a: • convertible note deed poll; • subscription letter; and • convertible note certificate. | You will require a: • subscription agreement; • shareholders agreement; • members register (update); • share certificate; and • ASIC Update Form 484. |
Key Takeaways
Both SAFEs and Convertible notes are often more convenient capital raising instruments that provide a host of benefits.
If you would like to understand the difference between them further or need assistance in drafting or reviewing a SAFE or convertible note, our experienced startup lawyers can assist as part of our LegalVision membership. For a low monthly fee, you will have unlimited access to lawyers to answer your questions and draft and review your documents. Call us today on 1300 544 755 or visit our membership page.
Frequently Asked Questions
Do I Have to Maintain a Register of SAFE and Noteholders?
Although there is no legal obligation to maintain a register, you will want to record all SAFEs and Noteholders in your capitalisation table. This practice helps you, as a founder and any other investors, understand the extent of dilution.
Do I need to value my company when issuing SAFEs or Convertible Notes?
No. This is one of the key benefits of issuing these instruments over a priced equity round. In a priced equity round, you must place a valuation on the Company in order to determine your share price. Determining the value of a start-up is a task that, especially at the early stage, founders consistently find difficult.
Should I set my valuation cap to what my company is valued at now?
This is a common misconception. You should negotiate your valuation cap to be as close to what you anticipate your company’s value will be at your next priced round. Setting a low valuation cap might mean giving away too much of your company, and investors often rely on the discount rate you set to ensure they get rewarded for the risk of investing in an early-stage startup.
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