SAFE or Convertible Note: Which Should I Choose?

Both SAFEs (Simple Agreement for Future Equity) and Convertible notes are hybrid investment vehicles used by investors and founders to fund startups. 

Founders need to choose which one to use. 

The Basics

Convertible Note

Convertible Note is a legal document that is nothing more than a loan with a twist. It’s just like a regular loan with an interest rate and maturity. Usually the interest rate ranges between 8% and 10%. The loan is typically payable within 2 or 3 years. 

The twist is that the investor has the option to convert the loan and the accrued interest into an equity stake in the company.

SAFE

Simple Agreement for Future Equity is a legal promise that in exchange for an investment, the founder will give the investor an equity stake in the company at a later date.

The key distinction you need to understand at this point is that SAFEs are not debt or equity. They are neither. They’re a binding legal agreement for equity that will be given to the investor in the future

Comparison

SAFE

Loan or Equity: Neither until conversion

Interest Rate: None. Investor expects ROI from increase in value of the startup

Maturity: None. Investor expects it will convert to equity at next funding round.

Execution Difficulty: Easy. Sign the legal docs and transfer money.

Conversion Timeline: Converts at next funding round

Conversion Method: Amount of equity granted at conversion is determined by this formula: Investment / Conversion Price

Balance Sheet Presentation: The investment will show up in the Equity section of the Financial Statement. This presentation is generally preferred because it makes the company look more liquid compared to debt.

Principal Protection: Yes. Clauses in legal docs protect investors from losing all their money, but in a liquidation or default proceeding SAFEs get paid after Convertible Notes if there are sufficient funds

Standard Users: Standard with institutional investors (i.e. venture capital funds) during seed rounds where the value isn't determined but also used by small investors. More popular in areas of the country where startup activity is high
 

Convertible Notes

Loan or Equity: Convertible Notes are a loan until conversion

Interest Rate: Standard rates average between 8% and 10%. There are usually no interest or principal payments made throughout the life of the note.

Maturity: Standard is 2-3 years 

Execution Difficulty: Easy. Sign the legal docs and transfer money.

Conversion Timeline: Converts at next funding round or Maturity (if investors chooses), whichever comes first. 

Conversion Method: Amount of equity granted at conversion is determined by this formula: (Investment + Accrued Interest) / Conversion Price

Balance Sheet Presentation: The convertible note will show up as Debt on the Financial Statements. Although it has not functional difference from a SAFE, debt has a negative perception in most people's minds because it will reduce liquidity

Principal Protection: Yes. Clauses in legal docs protect investors from losing all their money. Because it's structured as Debt, it has preferential treatment to equity holders or SAFE vehicles

Standard Users: Standard with smaller investors and angel investor. 

When Is Best to Use a Convertible Note?

  • Startup will become profitable soon and will have the funds to pay off loan
  • Founder wants the chance to minimize equity dilution by paying off the loan at maturity
  • Fundraising from Inexperienced/Small Investors
If any of the above apply to your situation you should consider a Convertible Note instead of a SAFE. 

The Equity Dilution Avoidance Strategy

Naturally, most founders want to keep as much ownership of the company as possible and if the company expects to be profitable in the near future and the profits can be used to pay off the loan  then a Convertible Note will afford you the option to do that.

Here's how it works (it's super simple and familiar to most): 
  1. Raise funding needed for growth using a convertible note 
  2. Become profitable and accumulate enough reserves to pay off the loan
  3. Pay off the loan plus interest at maturity
Seem familiar? - that's how traditional loans work. It's easier said than done so make sure you have a very strong financial model and have prepared your financial projections and plans. Run the numbers on this to see if it will work. 

 However, consider sharing this desire with the investor in case they strongly desire an equity stake. For most investors, the standard 8% to 10% interest rate doesn't compensate them for the risk of investing in a startup but if they're fine with just getting the interest, then this could be a great situation for everyone. Without this conversation, you may end up spoiling relationships. 

Also, if you take this strategy make sure the business will be able to sustain its own organic growth without the capital. Otherwise you may end up having to raise again. 

When Is Best to Use a SAFE?

  • No profitability in near future
  • Founder doesn't want to be in a position to have to pay off the loan before a liquidity event like a sale of a company
  • Fundraising larger amounts from institutional investors
If any of the above apply to your situation you should consider a SAFE instead of a Convertible Note. 
If the startup is not expected to become profitable in the near future, there's no reason to design funding structures that would require you to return they money you just raised because the startup is unlikely to have the funds required to do so. 

Larger amounts are also best suited for SAFEs because the added interest on a larger amount can become significant.