Convertible Notes and SAFEs

If you are a startup looking to raise your seed round, there are two very common investment instruments that you will most likely be using. These are the convertible note and the SAFE. The purpose of this post is to educate you on what these instruments are, and how they work. Hopefully after reading, you will be armed with the basics that will give you a leg up in negotiating.

What is a convertible note?

A convertible note is a debt instrument, and by it’s nature comes with an interest rate and term for repayment. The investor “loans” money to the startup at a negotiated interest rate for a certain length of time. However, the investor does not plan to collect monthly payments from the startup. Convertible notes contain conversion mechanics, hints the name, that will convert the amount “loaned”, plus interest, into equity. The investors main goal and hope is that the note will convert into equity with the next round of financing.

Convertible notes contain 2 conversion mechanics. They are the conversion event and the conversion price.

The Conversion Event:

Convertible notes may convert into different types of equity on the occurrence of any of the following events:

  • The closing of a subsequent equity financing of at least a certain minimum size (Next Equity Financing Conversion).
  • The sale of the company or substantially all of its assets (Corporate Transaction Conversion).
  • Reaching the maturity date of the notes before closing a subsequent equity financing or sale of the company (Maturity Conversion).
A next equity financing conversion happens when there is a preferred stock financing, usually your Series A. In this scenario, the principal and interest of the convertible note converts into the same shares of stock that the new equity investor purchased in the subsequent financing round, but at a discount (which we will discuss later).
 
A corporate transaction conversion happens when the startup is sold and the convertible note is still outstanding. When this happens, the investor has the option to either 1) receive the principal and accrued interest of their convertible note; or 2) convert the value of their note into shares of common stock at a discount to the price of the common stock the acquirer is paying or convert at the valuation cap (which will be discussed later).
 
A maturity conversion happens when the startup reaches the maturity date without having triggered a next equity financing conversion or a corporate transaction conversion. If this happens, the investor usually has the option to either 1) convert their notes into shares of common stock usually at the price implied by the notes’ valuation cap; 2) demand repayment; or 3) leave the notes outstanding. Most investors choose option 3.
 
The Conversion Price:
When a conversion event occurs the convertible note investor will receive equity based on the principal and interest balance of their convertible note, but at a price that is lower than the price paid by the new equity investor. The lower price paid is calculated based on one of the following:
  • The discount rate or;
  • The valuation cap.

The discount rate states that upon note conversion, the investor gets a percentage off the price per share that the new equity investor receives at the next equity financing or the price per share of the common stock that the acquirer of the startup is paying. The percentage discount usually ranges from 10%-30% with 20% being the most common.

The valuation cap is a ceiling on the pre-money valuation at which the note may convert at a next equity financing event. The cap ensures that the investor will still have a meaningful stake in the startup if it achieves an unusually high valuation in its next financing round. Caps range anywhere from $3 to 5 million on the lower end and $8 to 10 million on the higher end for a seed-stage convertible note financing.

As mentioned above, whichever one achieves a lower price per share to the investor is the one that applies upon conversion. For example, lets say an investor has a $500k note with a 25% discount rate and a $4 million valuation cap, and the fully diluted capitalization (shares outstanding + option pool) is 10 million shares of common stock. At your Series A round, your pre-money valuation is $7 million dollars and the price per share the Series A investors are paying is $0.70.

  • Under the discount rate, the investor would get a price per share of $0.53. This is calculated by using the following equation: Series A price per share * (100% – discount). So in this case it would be $0.70 * (100% – 25%) = $0.53.
  • Under the valuation cap, the investor would get a price per share of $0.40. This is calculated by using the following equation: valuation cap / fully diluted capitalization. So in this case it would be $4,000,000 / 10,000,000 shares = $0.40.
In this example the note would convert at the valuation cap since it produces a lesser price per share at $0.40 than the discount rate at $0.53, and the investor would get 1,250,000 Series A shares ($500,000 / $0.40 = 1,250,000).

What is a SAFE?

A SAFE, or a simple agreement for future equity, is a fairly new investment instrument that was created by the famous incubator, Y Combinator. It is very similar to a convertible note but it does not have an interest rate or maturity date. The absence of these two features makes this instrument very startup friendly.

The SAFE has the same conversion events (minus maturity conversion) and conversion price mechanics as a convertible note. However, given the nature of the instrument and its startup friendly nature, you will be hard pressed to find investors outside of the coasts who would be willing to invest through it.

Practical Advice

Convertible note and SAFE seed rounds are cheap, quick, and easy to close. However, that doesn’t mean you should give them out to everyone. As we will discuss in future posts, there can be some unforeseen consequences when convertible notes or SAFEs convert into equity at your next round.