By Doug Bend, Founder of Bend Law Group, P.C.a law firm focused on small businesses and startups.
Startups raising their first round of capital need to decide what type of investment vehicle to use.
The two most popular options are convertible promissory notes and SAFEs, or a simple future equity agreement.
Convertible promissory notes and SAFEs are similar in that the startup now gets investment capital in exchange for the investor’s opportunity to convert their investment into equity if there is a trigger event – such as a series A ride – on the road. A key difference is that unlike convertible promissory notes, SAFEs have no interest rate or maturity date.
Convertible promissory notes used to be more popular, but the growing trend is that most startups are using SAFEs instead, for four reasons.
1. No interest rate
Unlike convertible promissory notes, SAFEs do not include an interest rate.
As such, startup founders need to give up less equity in their business by using SAFEs instead of convertible promissory notes with comparable valuation terms.
2. No due date
Unlike convertible promissory notes, SAFEs have no maturity date.
The maturity date of convertible promissory notes is often 18 or 24 months. Startups that use SAFEs instead don’t have an impending maturity deadline.
If a startup uses a convertible promissory note and the note has not been converted by the maturity date, investors have the power to negotiate better terms in exchange for an extension of the maturity date.
3. Speed and simplicity
SECURITY means Easy agreement on future equity, which can lead to faster investment cycles that not only often cost less money in legal fees, but are also less likely to burn through the relationship capital that founders nurture with investors.
For example, founders can send investors a red line indicating changes to SAFE models that have been open sourced by Y combinator. Experienced investors often look at these red lines, nod and focus only on the valuation cap that is in the SAFE because they know that the other terms in the SAFE are market and fair.
This helps facilitate rapid capital-raising cycles, which not only takes less time for founders, but also lowers the risk of an investor losing interest in the investment. This feature is especially valuable now that the investment landscape is rapidly changing.
4. Not a debt instrument
Unlike a convertible promissory note, a SAFE is not a debt obligation. This could make it easier for a startup to obtain traditional funding from banks, since there is less debt on the books with a SAFE compared to a convertible promissory note.
Of course, the reasons founders prefer SAFEs are the same reasons investors often prefer convertible promissory notes. Investors would prefer their investment to earn interest and have the ability to renegotiate the terms of the investment if the triggering event has not occurred by the maturity date. Additionally, investors might be more familiar and comfortable with convertible promissory notes because they have been in the startup ecosystem longer than SAFEs.
In short, if you’re a startup founder, you’d probably be better served using SAFEs. Whereas if you are an investor, you would probably prefer a convertible promissory note.
Either way, founders should be careful and work with their lawyer and CPA to ensure that the terms and amount of capital raised will not dilute their distribution of ownership in their business too much.
The information provided here does not constitute legal advice and is not intended to replace the advice of an attorney on any specific matter. For legal advice, you should consult a lawyer regarding your particular situation.