Convertible notes and SAFEs—The least you should know!
As most startups know, there can be substantial challenges when it comes to raising cash. There are also choices to be made when it comes to a seed investment and much to consider, such as long-term fund-raising goals and strategic plans. Entrepreneurs, what do you prefer, non-interest bearing simple agreements for future equity? “SAFEs” over traditional interest-bearing convertible notes?
Startups generally raise money which is usually through one or a combination of the following avenues:
• founder cash savings
• Selling goods or services
• University funding, grants or services
• Obtaining non-dilutive government or nonprofit grants
• Issuing common or preferred stock
• Incurring straight debt or convertible debt
• Selling hybrid securities and warrants
Convertible notes and SAFEs fall into the last category, with some characteristics of both equity and debt.
A SAFE is a “simple agreement for future equity.” Don't think of it as equity, and it's not debt. Think of it as a warrant. The SAFE was created by a creative team of lawyers working for the Y Combinator accelerator program in the San Francisco Bay Area to simplify seed-stage funding for startups with a catchy acronym. While ubiquitous in northern California, companies using the SAFE structure can be found all over the world. The SAFE, revamped in 2018, is being used more and remaining outstanding in greater duration, as companies navigate the pre-Series A waters for longer to get to a meaningful equity round.
Convertible notes and SAFEs
Convertible notes and SAFEs are defined as agreements taking place between a company and an investor to exchange shares in the future for funds today. The instruments function as follows: An investor gives the company cash now and receives the right at a future point in time, to convert that money into company stock, commonly at a significantly better rate than the investor would receive if they purchased stock from the company directly later.
Think of the SAFE as a convertible note with the event of default, interest, and maturity date provisions stripped out. They come in several forms, with the primary differences between them being interest and maturity.
• Interest—Founders like the SAFE because no interest accrues. Investors thus prefer them. SAFEs are not a debt instrument. Because SAFEs are not interest-bearing, you save a little dilution. Convertible notes can carry an interest rate in the range of 2% to 8%. The longer the notes remain unconverted, the more interest accrues, which keeps the founder's feet to the fire to convert them quicker by raising more money and faster.
• Lack of maturity date— A SAFE has an infinite duration, so they convert only when there is an opportunity to do so. A convertible note typically has a maturity date of between 12 to 24 months. At some point, convertible notes have to be dealt with, so that founders are accountable to investors. Generally, this happens near maturity when everyone understands what the plan is. The mathematical calculations in convertible notes upon conversion can be quite complicated (discount plus interest). They can be easily misunderstood.
• No event of default – because the SAFE is not a promise to pay back cash, there are no events of default. Combine this with no maturity date, and a SAFE investor can’t foreclose on a company and take it over. On the flip side—SAFEs bring more uncertainty for investors. A SAFE with no maturity date allows the founder to continue offering SAFEs and avoid converting, and indefinitely delaying the "what is the plan?" discussion.
• Ease of documenting – One of the purported advantages of the SAFE is that a short document documents it. A convertible note is typically recorded by multiple agreements, starting with a term sheet and then a purchase agreement, note, and voting agreement.
The logic for using convertible notes or SAFEs to amass cash—as opposed to taking on straight commercial debt or undertaking a traditional equity financing—is simple.
The shortcoming with traditional debt is that it is satisfied solely by the company giving the lender cash when the maturity date arrives, which can create problems for early-stage companies without a predictable flow of money. When the debt falls due, a startup without sufficient funds on hand may be forced to raise more funds via convertible notes, by the issuance of SAFEs, through a conventional equity financing, or by accumulating more debt to pay off prior lenders, or worse yet, a lender could foreclose upon the company’s assets. These means of obtaining money divert time and energy from the company's main business and can themselves accrue additional hefty expenses. Convertible notes and SAFEs circumvent these difficulties by allowing the debt to be repaid via the conversion of the invested sum into shares, conserving cash on hand.
A traditional equity financing forces a company to set a valuation at the worst possible timeThis is particularly challenging for early-stage pre-revenue companies that have little basis upon which to ascribe a positive valuation, much less market fit for the product. Convertible notes and SAFEs avoid this obstacle by facilitating the give-and-take of cash for shares in the future, effectively punting the valuation down the line to the time of a traditional equity financing—when the company is likely to have a resilient basis upon which to establish a positive valuation. Another benefit that convertible notes and SAFEs convey—in contrast to traditional equity financing—is that they do not require ceding any portion of company control to the investor at the time that the money is given. This effectively buys the company more time, perhaps a few more years, to develop without having the investor in the boardroom.
What we've seen in recent years
Series A rounds have become larger and with rising goalposts to get to Series A, also tightening, which is why we see companies staying in the seed and pre-seed stage for more extended periods. To stay alive, pre-seed and seed-stage companies have to raise multiple rounds of seed capital. As the runway extends, investors have to hold on for longer until conversion to shares.
In response to this phenomenon, Y Combinator released new forms of SAFE in Q4 of 2018 with two fundamental changes:
1. Valuation is measured post-money instead of pre-money
2. Removing pro-rata rights to participate in future rounds
There are multiple versions of the SAFE available on Y Combinator’s site, to address whether or not the instrument will include a cap on conversion, a discount to equity valuation upon conversion, with other versions including neither and both.
Outlook: Seed financing in 2020
With Series A deals happening later and later, and at larger and larger sizes, we believe that the SAFE and the convertible note will continue to be used by companies for seed and growth capital, not just for startups, and for longer periods. As we assess the market correction that is happening in March 2020, this trend could deepen.
Pro-investor or pro-founder terms will ebb and flow with the amount of capital available, investor sentiment, public company comparable valuations and multiples. As we wrap up Q1 in 2020, we are seeing a new focus on proving out the business model, the market fit, and potential future profitability before companies can get to Series A, and we expect further innovation in seed-stage financing instruments to evolve in response.
Obligatory Covid 19 update
If you are a company that has raised equity capital and in a cash crunch, we advise to take this opportunity to review your cash burn and make some hard decisions that you have been delaying. If considering whether to take a bridge convertible note, consider that an extension round on your existing series of preferred could be a much better deal. Convertible note discounts on future conversion and interest could be very expensive money. If you are worried about dilution to the common, consider whether it’s appropriate for key members of the management team to receive equity grants struck at the post-money 409A value to keep incentives aligned.
Final plug: Whether you're the company or the investor, always consult legal counsel to verify that the terms of any convertible note or SAFE are fully understood and agreed upon by all parties involved.
© 2020 Louis Lehot