Startup founders often face the decision of how to raise capital without immediately resorting to offering preferred stock. An effective alternative lies in convertible securities, specifically SAFEs (Simple Agreements for Future Equity) and convertible notes. This blog post aims to demystify these financial instruments, offering insights into their workings, benefits, and potential drawbacks.
Understanding Convertible Securities
Convertible securities are financial instruments that allow investment funds to be converted into equity at a future date. This flexibility is particularly appealing to early-stage startups that haven’t established a market valuation, providing a more expedient and cost-effective fundraising method compared to traditional equity rounds.
The Mechanism of Convertible Securities
These securities come into play during fundraising, offering a mechanism where cash investments are converted into company equity at a later stage, typically in line with the next preferred stock financing round. In certain scenarios, like a company acquisition, investors might opt for a cash payout instead of equity.
The Convertible Note
A convertible note is essentially a debt instrument that transforms into equity under specific future conditions, such as during a subsequent equity funding round. It is characterized by an interest rate and a maturity date, requiring repayment of the principal amount with interest if not converted.
How Convertible Notes Function
Valuation Cap: This cap ensures early investors benefit if the company’s valuation increases rapidly, converting their investment into equity at a pre-determined, favourable valuation.
Conversion Discount: Early investors receive a discount on the share price relative to later investors, incentivizing early investment risks.
Simple Agreements for Future Equity (SAFEs)
Emerging as a popular tool, SAFEs are equity-based instruments converting into stock during a future equity round. Unlike convertible notes, they don’t entail debt, maturity dates, or interest accruals. SAFEs are categorized into pre-money and post-money, impacting how conversion ownership is calculated.
The Dynamics of SAFEs
SAFEs include valuation caps and conversion discounts, similar to convertible notes. However, they convert at any raised capital amount in the subsequent preferred stock round, providing more flexibility compared to convertible notes.
Comparing SAFEs and Convertible Notes
| Aspect |
Convertible Notes |
SAFEs |
| Type | Quasi-debt | Equity |
| Valuation Cap | Yes | Yes |
| Conversion Discount | Yes | Yes |
| Maturity Date | Yes | No |
| Interest Accrual | Yes | No |
SAFEs often present an attractive option for founders seeking to avoid the complexities of debt instruments.
Pros and Cons of Convertible Securities
Advantages
- Efficiency and Cost-effectiveness: They involve simpler terms and lower legal fees.
- Deferred Valuation: Founders can gauge their company’s growth before setting a valuation.
- Control Retention: Less immediate dilution of ownership and control compared to equity rounds.
- Flexible Fundraising: Allows accumulation of capital from various investors over time.
Disadvantages
- Risk of Dilution: Excessive fundraising through these instruments can significantly dilute founder ownership.
- Implicit Valuation: Even with a cap, valuation considerations cannot be entirely ignored.
- Investment Challenges: Attracting further investment can be difficult without a defined lead investor.
For startups at the threshold of their growth journey, convertible securities like SAFEs and convertible notes offer a blend of flexibility and strategic funding opportunities. However, founders must carefully consider the long-term implications, including equity dilution and investment dynamics, to make informed decisions that align with their startup’s vision and financial goals.
Connect with us at Allied Legal on 03 8691 3111 or drop us an email at hello@alliedlegal.com.au to discuss anything related to using SAFEs or Convertible Notes.
The insights presented in this article are derived from ‘Convertible securities: SAFEs vs. convertible notes’ published to Carta on 22 May 2023.
