In Short
- Convertible Notes: These are loans to a startup that convert into equity upon specific events, such as future funding rounds or company sales. They may accrue interest and often include a discount rate for early investors.
- SAFEs (Simple Agreements for Future Equity): Introduced by Y Combinator, SAFEs are agreements where investors provide capital in exchange for the right to receive equity upon certain events. Unlike convertible notes, SAFEs are not debt instruments and do not accrue interest.
- Key Differences: Convertible notes are debt instruments that may include interest and have a maturity date, whereas SAFEs are equity instruments without interest or a maturity date. Both can include discounts and valuation caps to reward early investors.
Tips for Businesses
When choosing between a SAFE and a convertible note, consider factors like interest obligations, maturity dates, and the potential impact on company valuation. SAFEs offer simplicity without debt obligations, while convertible notes provide structured terms with potential interest accrual. Align your choice with your company’s financial strategy and growth plans.
Table of Contents
Australian startups are increasingly considering raising capital using a convertible note or a Simple Agreement for Future Equity (SAFE). Both a SAFE and convertible note are alternatives to a standard equity raise which sees an investor receiving shares in the startup in return for capital injection. Although there are similarities between a SAFE and convertible note, it is important to understand how they differ from both a traditional equity raise and from each other.
A convertible note has both debt and equity elements. Under a convertible note, an investor makes a loan to the startup which automatically converts into equity at a trigger event (in practice, the closing of a future equity round). Investors are rewarded for their early investment with a discount to the price per share paid by the equity round investors.
American seed accelerator, Y Combinator, created the SAFE. It’s similar to the convertible note, however, a SAFE is an equity structure, not a debt structure.
Key Features of a SAFE and Convertible Note
| Convertible Note | SAFE | |
|---|---|---|
| Investment | The investor loans money to the startup in return for equity if the company reaches a conversion event. | The investor pays money to the startup in return for a contractual right to receive equity if the company reaches a conversion event. |
| Interest | It is not a requirement to have interest payable on the loan. However, if it is included, the convertible note will specify the interest rate and method of calculation. This interest will often accrue and convert to equity along with the loan amount at the conversion or maturity event. | As the SAFE is not a debt instrument, no interest is payable. |
| Conversion Event | The convertible note will set out the event which triggers the loan to convert to equity. Commonly this will be an equity financing (a seed or series A round etc.) or exit event (sale, IPO, etc.) | The conversion event is generally the same as seen in a convertible note. |
| Conversion Rate | This governs how the loan will convert to shares at the conversion event. When a trigger event is a priced round, the conversion rate is the share price of the round less a discount. | The conversion rate is generally the same as seen in a convertible note. However, unlike a convertible note, no interest will have accrued which needs to be converted. |
| Discount | Convertible notes commonly include a discount to reward investors for investing in the business early and through a higher risk mechanism. If the investor’s discount is 15%, this means that they will receive 15% more shares for their investment than if they were participating in the round directly. | A SAFE also commonly contains a discount. |
| Valuation Cap | Some convertible notes will contain a valuation cap. This will set the maximum conversion price for the loan. An investor may wish to negotiate a cap so as to better control the equity stake that they are to receive. | A SAFE may contain a valuation cap. |
| Term | For circumstances in which the company does not reach the conversion event, the convertible note will have a maturity date. At this date, the startup will generally either have to repay the loan or it will automatically convert to equity at a rate predetermined by the convertible note. | A SAFE does not have a term or maturity date. This means that if the conversion event does not occur, the investor will never receive equity. This also means there is no need to track or negotiate deadlines which generally add to the stress of a raise. |
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Startups most commonly use a convertible note or SAFE in a seed round or in bridge financing between rounds. As more startups familiarise themselves with these instruments, investors will become more willing to invest in this way. If you have any questions about raising capital and how best to structure your round, get in touch with our startup lawyers on 1300 544 755.
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