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Seed Investment: Comparing SAFE and Convertible Notes

Posted by Melissa Hollis to Investment, Business Advice

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Seed investment on your mind? Every entrepreneur should understand his or her options.

Our financial experts have put together this comparison to help startup founders decide between simple agreement for future equity, or SAFE, and convertible notes.

 

SAFE as Seed Investment

SAFE is a new financial instrument created by the Silicon Valley accelerator Y Combinator. SAFE was created to provide simpler, more easily understood seed investment.

 

A SAFE is a warrant to purchase stock in a future priced round. In contrast, a convertible note is debt that has the right to convert into equity when you hit an agreed upon milestone.

 

When deciding which investment vehicle is best for you, make sure that it aligns with your situation and your strategic goals. Let's take a look the seven key variables you should use to determine which is right for you.

 

1. Simplicity

Convertible notes can be complex. A SAFE is a 5-page document that was created for the purpose of simple seed investment. Because simplicity is one of its primary goals, SAFE offers a straightforward option: SAFE doesn’t carry an interest rate and doesn’t have a maturity date.

 

2. Conversion to Equity

Both SAFE and convertible notes allow for a conversion into equity. The difference here is that while a convertible note can allow for the conversion into the current round of stock, or a future financing event, a SAFE only allows for a conversion into the next round of financing.

 

Also, convertible notes typically trigger only when a “qualifying transaction takes place” (more than a minimum amount dictated on the agreement) or when both parties agree on the conversion. The SAFE can convert when any amount of equity investment is raised. This is nice for simplicity, but it doesn’t give the control to the entrepreneur, which is why the convertible note looks to be the best choice for seed investment in this category.

 

3. Discount

Both instruments carry a discount on the next round (or current round for convertible notes), so neither presents a clear advantage to seed investment in this category.

 

4. Valuation Cap

Depending on your negotiating skills and your company’s traction, you can get a SAFE or convertible note without a valuation cap. However, it's pretty difficult to do in this environment with either instrument, so there is no clear winner for seed investment in this category.

 

5. Early Exit

If you're looking for an early exit, convertible notes and SAFE offer similar payout mechanism in the event of a change in control (acquisition/IPO) before a conversion can occur. The SAFE is written to give the investor the choice of a 1x payout or conversion into equity at the cap amount to participate in the buyout.

 

In our experience, there are typically 2x payout provisions in a convertible debt agreement, which can still be written into SAFE agreements. Both options have seed investment advantages in this category.

 

6. Interest Rate

SAFEs are not a debt instrument. Instead, they are defined as a warrant. That means they do not carry an interest rate. Convertible debt, however, can carry a simple interest rate ranging from a 2% - 8% (most falling around 5%). Since most entrepreneurs don’t need another expense, a SAFE is the clear winner in this category.

 

7. Maturity Date

Since a SAFE is not a debt instrument, it does not have a maturity date. Convertible notes have a maturity date, and this can cause some issues when the maturity date comes to pass. Once the maturity is reached, an entrepreneur has two choices: pay back the principle plus interest (if the company has enough money to do that), or convert the debt into equity.

 

The latter is difficult to negotiate if the company isn’t doing well, and investors want their money back. It could even trigger a bankruptcy. Since that is the last thing an entrepreneur would like to deal with, the obvious choice from this perspective is the SAFE.

 

Other Seed Investment Considerations

It's debatable as to whether a SAFE would trigger the need for a fair valuation (409a), which could require funds be allocated towards professional services and not towards building your awesome product.

 

Another thing to consider is that raising common stock doesn’t trigger a conversion for a SAFE investor, so entrepreneurs in need of some extra cash could do a "friends and family round" and avoid the conversion trigger if there is a need to bridge.

 

So What's the Best Option for Seed Investment?

From an entrepreneur’s perspective, when weighing these variables, it's pretty apparent that the SAFE is the most advantageous instrument for raising a seed investment. Why? Because it doesn’t require a maturity date, interest rate, or conversion (if you can hold out from raising a preferred series round).

 

Ultimately, SAFE is a fantastic tool for entrepreneurs to consider when they're looking to raise their initial rounds of seed investment.

Are you ready for your next round of funding? Download your guide to fundraising now. 

Looking for more information on SAFE Financing? Check out this link on Y Combinator's website.

Cover image courtesy of Tatters (via Flickr)

 

About the author
“Melissa

Melissa Hollis

Melissa Hollis is a content marketer and lover of all things West Coast. She enjoys waking up every day and getting the chance to rethink the obvious and enable the dreams of aspiring entrepreneurs.

Success starts when you take charge of your finances.

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