When it comes to startup financing, two instruments often used are convertible notes and safe notes. Both serve the purpose of delaying the valuation of a company, but they have distinct features and implications. Let's delve into the details of each and compare them to help you make an informed decision.
Before we dive in, it's essential to understand that convertible notes and safe notes are debt instruments that convert into equity at a later date. They are typically used in early-stage funding rounds to provide capital to startups while delaying the valuation process.
Convertible Notes
Convertible notes are a type of debt that converts into equity at a later date, usually at the time of a priced round. They are similar to traditional loans but with some unique features.
Convertible notes are often used because they allow investors to participate in future funding rounds at a discount. This discount is typically around 20% to 30% of the price per share in the next funding round.
Maturity Date and Interest
Convertible notes have a maturity date, typically 18 to 24 months from issuance. If the startup hasn't raised a priced round by the maturity date, the note converts into equity at a discount. If the startup hasn't raised a priced round and can't pay back the note, it's considered a default.
Convertible notes may also accrue interest, which can be compounding or simple. This interest can also convert into equity at the time of conversion.
Conversion Cap
A conversion cap is a feature often included in convertible notes. It sets a ceiling on the price per share at which the note converts into equity. This cap provides a safety net for investors, ensuring they don't convert at a price per share higher than the cap.
For example, if a startup is raising a Series A round at a $10 million post-money valuation, and the conversion cap is $8 million, the note would convert at a $8 million post-money valuation, even though the Series A round is at a higher valuation.
Safe Notes
Safe notes, or Simple Agreement for Future Equity, are another type of debt instrument that converts into equity. They were introduced by Y Combinator to address some of the issues with convertible notes, such as the need for a maturity date and the potential for significant dilution.
Safe notes don't have a maturity date or accrued interest. Instead, they convert into equity automatically when a startup raises a priced round. This makes them simpler and less risky for both startups and investors.
Discount and Cap
Like convertible notes, safe notes also have a discount, typically around 20% to 30%. However, safe notes don't have a conversion cap. Instead, they have a valuation cap, which sets a ceiling on the pre-money valuation of the startup at the time of conversion.
For example, if a startup is raising a Series A round at a $10 million post-money valuation, and the valuation cap is $8 million, the safe note would convert at an $8 million pre-money valuation, even though the Series A round is at a higher valuation.
Most-Favored Nation (MFN) Provision
Safe notes often include an MFN provision. This provision ensures that if a future investor gets a better deal (like a higher discount or a lower valuation cap), the safe note holders get the same deal.
For instance, if a future investor gets a 30% discount, the safe note holders would also get a 30% discount, even if their original note only had a 20% discount.
In the dynamic world of startup financing, it's crucial to understand the intricacies of convertible notes and safe notes. Both instruments serve a purpose and have their advantages and disadvantages. The best choice depends on the specific needs and circumstances of your startup. It's always a good idea to consult with legal and financial professionals to make the right decision for your business.