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CAP RAISING FOR FOUNDERS: What’s a SAFE, a convertible note, and are they really better than a priced equity round?

Inside Man
Inside Man (2006) Universal
What’s a SAFE, what’s a convertible note, and are they really better for founders than raising investment in a priced equity round?

The short answer is that you can raise investment with a SAFE note or convertible note in Australia, but you might not necessarily find it easier to raise the money if you do.

Here’s the longer answer.

Priced equity rounds

In a priced equity round, you and the investors must first agree on a dollar figure amount for the value of the company (called “the pre-money valuation” or sometimes just “the pre-money” or “the pre”).

You and the investors must then agree on how much investment capital (money) the company needs to achieve its next set of goals (called “the investment round” or “the round”).

You and the investors must also agree how that investment capital will be provided — which investors will contribute what amount.

If there’s an investor that contributes more than any other investor, they are usually called “the lead investor” or “the lead” and they may expect to define many of the terms of the investment such as how much equity should be set aside for compensating early employees, what sorts of decisions the founders can make without board approval, who gets a board seat, and crucially, whether any investors get any special rights to get their investment back in case of the company going bust or being acquired (called “liquidation preferences” or just “prefs”).

Negotiating it all can take a lot of time. The riskier the investment is perceived to be, or the less interest from investors there is, the longer it can take.

Meanwhile, the startup might be struggling without sufficient cash for growth and supporting existing customers, or it might find that the value of the business has increased significantly because of the progress made since the first investors committed to the round, and now you have to go back and persuade those investors to pay more per share than they’d originally committed to. That can take even more time.

Time is the startup’s most precious asset, and we try to conserve it whenever we can.

So, the tech startup industry also uses two alternative forms of investment, called a ‘convertible note’ and a ‘SAFE note’ or “a SAFE”. They’re both designed to help you raise money faster, so you can get back to growing your startup.

 

How convertible notes work

A convertible note (or “con note”) is simpler than a priced equity round mainly because it postpones the negotiation of a pre-money valuation of the company until later. Instead of the startup offering shares to the investors, it offers a convertible note, which is a loan to the company.

The loan has a fixed term, and an interest rate that accrues over the term. The interest rate is negotiable, depending on how much the investors want to invest in your startup, and how much you want their money (there’s usually a going market rate which will vary, so check around with other founders who’ve recently raised on a convertible note).

At the end of the term, the investors participating in the convertible note can choose whether they’d prefer to have their principal back plus interest, or whether they would rather the loan be converted to shares in the company. There are usually terms in the convertible note, specifying some instances in which the loan automatically converts to shares, such as the completion of a priced equity round or the sale of the company. Those terms are there to reduce the investor’s risk, so pay attention to them, because when one side of the negotiation reduces their risk, the other side usually takes on some additional risk.

They usually include a “valuation cap” — a maximum valuation at which the investment made via the convertible note will convert into equity. This protects the investor against receiving only a minuscule amount of ownership in the company if the valuation of the future priced equity round gets set really high. Investors in the convertible note typically get converted at the lesser of: (a) the valuation of the next qualified priced round; or (b) the valuation cap.

To compensate the investors for making an unsecured loan to a high-risk tech start- up, it’s common to offer a discount on the conversion from debt to equity when the convertible note converts. How much of a discount depends on how much the investors want to invest and how much you want their investment, but also on the current market conditions, and you should check with other founders who’ve recently raised to try to establish a current range of discounts on conversion.

You don’t need to negotiate a pre-money valuation, the paperwork is usually shorter (meaning cheaper to do with your lawyer and accountant) and you don’t always need to agree on the size of the round you’re raising before you start banking the money — some startups will hold a convertible note open for some time, banking fund transfers from investors as they come in.

 

Why convertible notes aren’t always a better way to raise

In the US, convertible notes are commonly used for pre-seed and seed investment rounds and are an established way of investing in startups. In Australia, convertible notes are used, but are less common, partly because we’re just generally a bit behind the times, but more often because more Australian tech investors are new to investing in this sector and more conservative in making investment decisions.

Some Australian investors feel that convertible notes have more risk for them than a priced equity round because, until a priced equity round occurs, the investors don’t have a valuation on the company and hence don’t know how much of the company they own.

In general, Australia sees less competition between investors, lower valuations at each round, and more time between rounds. Each of these tends to take a bit of heat out of the competition between investors, which tends to make Australian investors more likely to prefer priced equity rounds to con notes.

As a founder, you need to remember that your convertible note funds are a loan and hence a debt that needs to be repaid, and also a debt which needs to be accounted for in your fiduciary responsibilities to the company. For instance, you can’t allow your startup to trade while insolvent, which could happen if you forget to account for one or more convertible notes that have yet to convert to equity. Multiple convertible notes are quite complicated to account for correctly.

 

What is a SAFE?

SAFE is in all-capitals because it’s an acronym that stands for “simple agreement for future equity”. “Simple” is a relative term meaning “simple if you’re a lawyer” but a SAFE note usually does have fewer pages, fewer clauses and is simpler to comprehend.

While a convertible note is a debt, a SAFE note is not debt: a convertible note includes an interest rate and maturity rate, a SAFE note doesn’t.

Some SAFE notes (particularly in the US) don’t include a valuation cap, or a discount on conversion to equity. Whether your SAFE note does — or does not — depends upon how much you and your potential investors want to make the deal happen.

 

Why a SAFE isn’t always a better way to raise

You can hold a SAFE open like you can a con note, banking the money from each investor as they sign on, but don’t forget this means you’ll still have to show rapid forward progress to subsequent investors who you’re persuading to join a SAFE.

If you take a year to raise a lot of money in a priced equity round, that’s not necessarily better or worse than banking a tenth of that amount from your first eager investors in a SAFE and then finding it hard to raise the rest of the money you need because the first cheques weren’t enough to fund rapid growth.

Generally speaking, SAFE notes mean less risk for the startup founder and more risk for the investor. But more risk for the investor can translate into more caution, less enthusiasm, and more persuasion required over a longer time to get a deal done.

So at times and in sectors, markets and geographies where investors are falling over each other to get into the best investments, and funding rounds are much closer together, SAFE notes can work. In Australia, where there’s less competition between investors, less momentum and less FOMO, it’s definitely harder to raise on a SAFE than a convertible note, and harder to raise on a convertible note than on a priced equity round.

 

Credits to: startupdaily.net

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