SAFE vs. Convertible Notes: A Founder’s Guide to Startup Financing

The right investment instrument is important when raising early-stage capital for your startup. Two of the most popular options many startups consider are Simple Agreements for Future Equity and Convertible Notes. Both solutions aim to provide ease in raising money for a startup without having to tentatively ascertain the valuation of the company. But they come with different structures, advantages, and risks. In this blog, we’ll explore SAFE vs. convertible notes to help you make an informed decision.

What Are Convertible Notes?

Convertible notes are a type of short-term debt that later converts into equity, typically in conjunction with a company’s next round of financing. Here’s how:

• Debt Instrument: A convertible note is, in essence, only a debt instrument, a type of loan to the company with a set maturity date and oftentimes an interest rate.

• Conversion to Equity: When the loan is due, instead of paying it out, the debt converts to equity in a future raise. It normally happenns at a discount to the future equity price or with a valuation cap.

• Maturity Date: Convertible notes bear a maturity date. It means that if the company does not raise another round of financing by a certain maturity date, the holder of the convertible note will demand repayment or convert the note into equity. 

• Interest Rates: Convertible notes are normally interest-accruing, which adds to the total of what is being converted into equity.

What Are SAFEs?

SAFE stands for Simple Agreement for Future Equity. It was developed in 2013 by Y Combinator. It is essentially a type of convertible note with a few key distinctions:

• No Debt Component: Unlike convertible notes, SAFEs are not debt instruments. They don’t have an expiration date nor bear interest, eliminating the pressure for repayment from the company. 
• Equity Conversion: This is like convertible notes because SAFEs convert to equity during a future financing round. The main difference is usually at a discount or with a valuation cap.

• Simplicity: The ultimate goal of the creation of SAFE notes is to make a much simpler and more founder-friendly document. They get rid of complexities associated with debt, like interest rates and maturity dates.
• Multiple Triggers: SAFEs can convert to equity under various circumstances, from an acquisition to an IPO, adding to the flexibility.

SAFE vs. Convertible Notes: Key Differences

While both SAFEs and convertible notes are intended to delay valuation discussions down the road to the next financing event, they are otherwise quite different in some critically important ways:

• Debt vs Equity: Convertible notes are a debt instrument with some features of debt—maturity date and interest. While SAFEs are merely an agreement for future equity with no evidence of debt.

• Risk: Convertible notes are debt-based. Founders take more risk because if the conversion event does not take place at the maturity date, the debt has to be repaid. SAFEs contain no element of debt.

• Investor Protection: Convertible notes may offer the investor more protection as a result of the debt feature and the opportunity to demand repayment upon maturity. SAFEs are less protective, but on the other hand, they are more straightforward and, in most cases, seem acceptable to the early-stage investor, who is actually looking for equity rather than debt. 

• Relative Complexity: By and large, SAFEs are pretty straightforward and easier to execute; hence, they make for a faster route toward the close of a round of funding. The clause on interest rates and maturity dates—together with other provisions—can make convertible notes a bit more complex to manage than plain equity or even SAFEs.

SAFE vs. Convertible Notes: When to Use Each

The choice between using SAFE vs. convertible notes depends on the particular needs of your startup, its goals, and what kind of relationship you are having with investors.

• Use a SAFE when: You’re looking for an only simple, founder-friendly agreement without all of the complicated issues involving debt. SAFEs are very appropriate at a very early stage of startups when all that matters is getting capital in fast, and repayment isn’t worth worrying about. 
• Use a Convertible Note when: You’re raising a larger seed round and the investors want more protection through the debt structure. Even in this case, convertible notes can be attractive if your investors really are quite traditional and they want the extra security of having a loan.

Conclusion

Making a choice of SAFE vs. Convertible notes is a crucial one because it will set the foundation of your financial structure and relations with investors. Quiet, simple, and perfectly aligned with early fundraising, a SAFE is an easy and intuitive document to create and agree upon. Convertible note investments are far more secure for the investors, but this fact, in turn, brings greater complexity and increased risks for founders.

In the end, the right choice depends on your individual situation: the stage of your startup, the amount of capital you are raising, and your investors. At least understanding the differences among these instruments will help you negotiate better and put your startup on the path to success.