SAFEs vs. Convertible Notes vs. Priced Rounds – Financing your pre-seed startup

So you’ve decided to take the plunge and become a founder of what you hope will be an extremely successful company. But of course you need investment and you need to choose the best option for raising money to ensure your idea is able to get off the ground.

There are four ways to go about this. You can borrow money from the bank, raise with a SAFE, do a convertible note, or undertake a priced round. Some time ago, priced rounds were the only option, then YC came out with a SAFE and convertible notes also became popular. However, they were complicated and expensive options, as founders had to pay high lawyer’s fees.

SAFEs have associated problems, but now that SeedLegals has made it easy and inexpensive to do a priced round, you may want to consider it as your primary investment option.

In this article we’re going to demonstrate which option may be right for you.

What is a SAFE?

This is usually what people think of when they’re talking about startup funding. It’s when the company takes money now with a promise to investors that they will receive future shares in the company. There is no debt to repay, and SAFEs, unlike convertible notes, may have no deadline for conversion.

To some extent, the SAFE is a slimmed-down convertible note, with the obligation to repay debt stripped out.

How are SAFEs used today?

The SAFE was designed to be a faster and simpler way to agree deal terms and has become the most often-used financing instrument for raises of up to $3 million.

Are SAFEs right for your funding needs?

The advantage is that SAFEs are extremely easy to create, as it’s a simple agreement. The disadvantage is that it doesn’t come with the investor rights and protections that are present in a priced round. Also, it may be years before the SAFE converts into equity.

Another important thing to note is that because a SAFE is an equity investment, the investor holding a SAFE is not a shareholder or board member with shareholder or other oversight or voting rights. Hence, not all investors are willing to sacrifice the leverage an equity holder (shareholder rights) or a debt holder (repayment rights) might hold over the company.

To address this, many SAFE agreements include side letters detailing additional terms and conditions, which may reassure investors but which may also increase the time, negotiation, legal costs and process of financing that SAFEs and convertible notes were meant to reduce when compared to equity financing.

If a SAFE doesn’t seem right for you and/or your investor, you could consider convertible notes.

What is a convertible note?

A convertible loan agreement means that the investor gives you money now and when you do the next funding round, you can elect when creating the note that it will either convert into equity or be repaid. In the meantime it may accrue interest.

Of course, if you elect for it to be repaid, you need to ensure that you have the capital to repay the money. If not, you may face bankruptcy and go out of business.

Discount amounts on convertible notes can vary. 20% is typical, but the amount is, of course, determined by the amount of time taken for the note to convert into equity. They may include a discount, or a valuation cap, or both. A valuation cap protects investors in future scenarios in which the company turns out to be super-successful and raises its next equity round at a very high valuation, leaving the early-risk-taking convertible note holders with a very small share of the company. A valuation cap places a ceiling on the valuation at which the convertible debt holders’ loan will convert.

The benefits of consistency of convertible notes

Convertible notes may include a Most Favored Nation (MFN) clause to ensure the earliest note holders are treated as well as the best of your later note holders.

MFNs state that if any future note holder receives more favorable terms than the signer of the current note, such as a higher discount, a lower valuation cap, a higher interest rate, or other preferential terms, then the current note holder is entitled to upgrade to these more favorable terms as well. This ensures parity across all investors in your convertible notes round, no matter how many small transactions spread across how long a time period this round may entail.

Plus, you also need to be super careful about giving out MFNs to investors, because if you give anybody else better terms, the current investor is going to get the best terms as everyone else. And if you give out multiple MFNs, if something goes wrong with your business and you have to give an investor in the future a really good deal, it can lead to massive dilutions. So you want to give an MFN to as few people as possible and agree terms upfront.

In the past, maintaining a spreadsheet with different terms was troublesome, but now, thanks to SeedLegals, things are so much easier as the platform sorts it for you. The SeedLegals online cap table builder takes care of the arithmetic, calculates equity dilution and keeps tabs on who owns what so you don’t have to.

Advantages of convertible notes for founders

Convertible notes can be a powerful tool for fast, agile fundraising and allow you to take in a one-off investment ahead of a full-priced funding round.

They can make it possible to pick up smaller amounts of capital, typically up to three million dollars and raised without going through detailed due diligence, shareholder agreements, or company valuation. The conversion into equity can be deferred until a later (and typically larger) priced equity round, whether that round is with a business angel or angel syndicate, an accelerator, a VC, a private equity firm, or some other qualified investor.

As part of the pros and cons of convertible note agreements, their speed and efficiency can be a great advantage, particularly at a company’s earliest stages.

Disadvantages of convertible notes for founders

The disadvantage of convertible notes is that it can put founders under pressure to repay. For example, they typically have a term and maturity date, such as five years. If the company has not raised a priced equity round triggering the convertible note’s conversion to equity, then the convertible loan becomes due for cash repayment.

If the company has not triggered conversion prior to the debt maturity date, founders may ask the debt holder to extend the term for another year or two and many will – but the debt holder is not required to and may now seek to exercise their significant leverage over the company to demand either repayment or renegotiated terms.

Time can also work against founders when the terms of a convertible note include both interest accumulating on the loan and a valuation cap. Over time the investor’s future stake is growing as their loan is accruing interest and the amount that will convert is getting larger. The founders therefore see their own future stakes correspondingly shrinking month by month.

Interesting to note is that SAFEs seem to be the more favored option on the west coast, whereas on the east coast it’s more of a mixture of convertible notes and SAFEs.

Tax implications of SAFEs and convertible note

When it comes to knowing about Qualified Small Business Stock (QSBS), the tax break founders need to know about, an investor who has acquired QSBS (Qualified Small Business Stock), which is a share of a Qualified Small Business, can exclude up to 100% of capital gains realized from their Federal (and some state) taxes if the company issuing the shares meets QSBS criteria.

Many startups do meet the criteria, which depend on company size and industry and whether the stock was acquired directly from the company or via a secondary market transaction.

Options, warrants and convertible notes can be considered to be QSBS eligible for capital gains exclusion, but only after conversion. SAFEs are a hybrid instrument, neither options, nor warrants, nor debt.

What is a priced round?

A priced round means early-stage founders will at this stage, sell common or preferred shares of the company to investors. In a funding round, the value of the company is what the owners (founders) and the investors agree upon.

Priced rounds used to be enormously expensive, but SeedLegals has made it more cost-effective compared to going through a law firm. We are the first in the world to do US-priced rounds as a way of gaining critical investment.

So finally, you have the option of being able to choose between SAFEs and priced rounds.