When a startup is ready to raise its initial round of financing – known as a “seed” or “friends and family” round – the startup and prospective investors must determine how to structure the financing. The conventional way to structure a modest seed round is through the sale and issuance of convertible notes.
However, in recent years, SAFEs (Simple Agreement for Future Equity) have gained popularity in the startup and angel communities as a simpler and more practical seed investment instrument. This article provides a brief overview of SAFEs and how they compare to convertible notes.
What is a Convertible Note?
To provide context for SAFEs, it is helpful to understand the features of a convertible note.
A convertible note is a debt security in which an investor loans money to a company in exchange for a written promise (the convertible note) to pay the investor back. Convertible notes include the following features:
- a principal balance (the investment amount);
- an interest rate;
- a maturity date by which the company must pay the investor back (or after which a majority-in-interest of the investors can demand that the company pay them back); and
- conversion of the principal and accrued interest of the note into the preferred stock issued by the company in a subsequent equity financing round of a minimum size, typically at a discount based on a percentage of the per-share price offered in the round or a maximum pre-money valuation of the company (known as a “valuation cap”).
For experienced investors, conversion is the most important feature of the note. The goal of a convertible note investment is to receive preferred stock, on the terms negotiated and determined by a VC or other institutional investor, at a discounted price. The preferred stock will have a much higher upside than repayment of the principal and interest on the note.
What is a SAFE?
SAFEs are a relatively new type of investment security, created and popularized by the leading startup accelerator Y Combinator. SAFEs were developed to be a more straightforward alternative to a convertible note.
A SAFE is, literally, a Simple Agreement for Future Equity. Investors in a SAFE receive an instrument that includes the conversion features of a convertible note – namely that their investment will convert, at a discount, into the preferred stock issued by the company in its next equity financing round – but without the debt features of an interest rate and maturity date.
Startups prefer SAFEs to convertible notes for several reasons. First, because they lack a maturity date, founders do not have to fear the possibility of reaching the maturity date prior to conversion. Second, unlike convertible notes, SAFEs are typically issued in a stand-alone format, with each investor receiving its own SAFE, a relatively straightforward document, within a series of identical SAFEs. This is a simpler format than a convertible note financing, in which the company and investors typically enter into a master Note Purchase Agreement containing various terms, representations, and conditions and also a separate convertible note with each investor. Finally, because of the reduced compilation and paperwork involved in a SAFE financing, they are fast, easy, and inexpensive.
Investors are increasingly willing to invest in SAFEs. While the lack of a maturity date and interest rate are potential drawbacks for investors, the purpose of their investment is to receive preferred stock at a discounted rate. As such, convertible note investors rarely exercise their repayment rights at maturity (and the company will not typically have the funds to make repayment at that time) and focus more on the conversion discount than the interest rate.
In addition, many early-stage investors are either too inexperienced to appreciate the terms, representations, and conditions of a Note Purchase Agreement and convertible note, or too experienced to care about them in an early-stage round. A SAFE is a simple instrument that accomplishes the primary goals of both the company and investors without any added complexity.
As a new-ish instrument, the tax treatment of SAFEs is not well established. SAFEs lack both the typical characteristics of debt and the typical characteristics of equity. So, for tax purposes, SAFEs could reasonably be characterized as debt, equity, or potentially a derivative instrument similar to a prepaid forward contract. The current and future tax liabilities and benefits of a SAFE depend on that characterization. Due to that uncertainty, some investors may prefer the vetted tax treatment of a convertible note or feel uncomfortable taking an uncertain or aggressive tax position with respect to a SAFE.
SAFEs provide the features and simplicity valued by both startups and early-stage investors. SAFEs are becoming increasingly common and are likely to have broad appeal as investors become familiar with them. Expect to see SAFEs gaining on convertible notes as the seed instrument of choice in the coming years.
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Russell Terry is a Partner in Reicker Pfau’s corporate group.