Overview of Convertible Note, SAFE and Equity Financing
Startups and businesses often need to raise funds to finance their operations, growth, and expansion. This blog post examines the key features of the three most common fundraising methods in startup finance: (1) Convertible Notes, (2) Simple Agreements for Future Equity ("SAFEs"), and (3) Equity Financing, with a comparison of the advantages and disadvantages of each method.
The Basics
There are two main ways to raise money for a private company: debt and equity.
Debt: Company borrows money from lenders, such as banks or investors, with an obligation to repay the principal amount along with interest over a specified period or whenever the lender demands. This method of financing allows businesses to access capital without diluting ownership or control.
Equity: Company issues shares of its stock in exchange for capital from investors. This method dilutes existing ownership stakes but does not require repayment like debt financing. Instead, shareholders expect returns on their investment through potential appreciation of share value and dividends as the company grows and becomes profitable.
Definition and Features
Convertible Note
A convertible note is a debt instrument that can be converted into equity shares in the company at a later stage. It offers investors an optimal combination: the debt feature provides protection against losses, while the equity feature allows for potential gains. It typically includes the following features:
Interest Rate: A convertible note accrues interest over time, which is added to the principal amount when the note converts to equity.
Maturity Date: The note has a maturity date when the principal and accrued interest are due if the note has not been converted to equity.
Conversion Trigger: The note specifies events that trigger its conversion into equity, such as a qualified financing round or reaching a predetermined valuation.
Valuation Cap and/or Discount: The note may offer a discount or valuation cap on the company's valuation during the conversion, providing the note holder with more shares for their investment.
SAFE
Initially introduced by Y Combinator in Silicon Valley a decade ago, a SAFE strips the debt nature of Convertible Note while keeping the equity feature. It gives investors the right to receive equity shares in the company at a later time, usually upon a triggering event such as a priced equity round or a change of control. Specifically, at the time of conversion in connection with a priced round, SAFE holders would receive Preferred Stock of the Company - typically the same class of stocks that the new investors receive in the priced round, with preferential rights such as liquidation preference and anti-dilution protection.
Key features of a SAFE include:
No Interest or Maturity: Unlike convertible notes, SAFEs do not accrue interest and do not have a maturity date. SAFE is not a debt instrument.
Conversion Triggers: Similar to convertible notes, SAFEs specify events that trigger the conversion into equity.
Valuation Cap and/or Discount: SAFEs typically include a valuation cap, which sets a maximum valuation for the conversion, and/or a discount on the share price during the conversion.
Pre-Money vs. Post-Money SAFE
In 2013, the original SAFE introduced by Y Combinator was a Pre-Money SAFE, which calculates ownership percentages based on the company's valuation before new investments were made. However, this approach sometimes led to uncertainties regarding dilution and ownership stakes between founders and investors. To address these concerns, Y Combinator updated the SAFE in September 2018 by introducing the Post-Money SAFE. This new version calculates ownership percentages based on the company's valuation after accounting for all the SAFEs and new investments, arguably providing greater clarity and transparency for both parties involved in the fundraising process. Many VC bloggers have written extensively about why founders should not adopt the standard YC Post-Money SAFE, but let's understand what they are first.
Stepping back into SAFE conversion mechanics: SAFE conversion price equals the smaller of (i) lowest price per share of the new Preferred Stock in the next equity financing round, (ii) Discounted Price (if there’s a discount), or (ii) Cap Price: the price per share equal to the Valuation Cap (either Pre-Money or Post-Money) divided by the "Company Capitalization").
Therefore, the Pre-Money vs Post-Money distinction only matters when the SAFE has a Valuation Cap. Founders would want the value of "Company Capitalization" to be as small as possible, resulting in a higher price per share for SAFE investors. On the other hand, SAFE investors would want the value of "Company Capitalization" to be as big as possible, resulting in a smaller price per share for their investment through the SAFE.
Now let's unpack the definitions of "Company Capitalization" in YC's Pre-Money SAFE (i.e., the Original SAFE) and Post-Money SAFE:
Source: Y Combinator SAFE User Guide
Therefore, when you are running a simulation of how the SAFEs would convert or building a Pro Forma for your next priced equity round, it is important to pay attention to what is included in or excluded from the definition of "Company Capitalization" in the SAFE.
Example A. If you sign a Pre-Money SAFE with Investor #1 today and issue another SAFE to Investor #2 in three months, both you and Investors #1 would be diluted by Investor #2's SAFE when it comes to conversion time.
Example B. If you sign a Post-Money SAFE with Investor #1 today and issue another SAFE to Investor #2 in three months, only you the founder are being diluted by Investor #2's SAFE because Investor #1 has locked in his/her equity percentage immediately prior to the next priced round.
As of the date of this blog post, YC has three forms of SAFEs published on its website:
Post-Money SAFE with Valuation Cap and No Discount
SAFE with Discount and No Valuation Cap
SAFE with Most Favored Nation Clause with no Valuation Cap or Discount
In addition to the three forms published on YC's website, there are other permutations of SAFEs companies can offer to investors, including Post-Money SAFE with both Valuation Cap and Discount, Pre-Money SAFE with Valuation Cap and Discount, Pre-Money SAFE with Valuation Cap Only. As a founder, remember that you don't have to adopt YC's standard forms to do a SAFE round and investors are not married to them. Depending on your financing plans, you should consult with your legal counsel to determine the best form to use and propose founder friendly edits to standard forms, especially if you have the power to dictate the terms.
Equity Financing
Equity financing refers to raising capital by selling shares (typically Preferred Stock) in the company to investors. In this process, investors provide funds in exchange for an ownership stake in the company. Equity financing involves determining the company's valuation, negotiating the ownership percentages and investors' control rights, and issuing new shares to the investors.
Advantages and Disadvantages
Choosing the Right Financing Method
Choosing the right financing method for your startup or business depends on various factors, such as:
Your company's stage of development and past financing history
Financial position and bargaining power
Institutional investors or family/friends
You may ask which method is the most common in startup finance these days. Between Convertible Note and SAFEs, I've noticed that SAFEs are becoming increasingly popular among investors (even outside of Silicon Valley) as a fast and efficient way to invest in companies. Investors typically would propose the standard YC Post-Money SAFE as a starting point (because it is so investor friendly) but many investors are also open to small variations and founder friendly edits as long as they are backed by reasonable explanations. My colleague has written about some of the founder friendly edits to SAFEs you can propose to investors. Most companies raising an equity round have done convertible note rounds prior to that. It is therefore essential to carefully consider the legal implications, advantages, and disadvantages of each method before making a decision.
Need help? If you're contemplating financing and would like to discuss how to maximize your interest in a convertible or equity financing round, don't hesitate to reach out for guidance and support.