Convertible Notes And SAFEs — The Least You Should Know! - Corporate and Company Law - United States (2024)

As most startups know, there can be substantial challenges whenit comes to raising cash. There are also choices to be made when itcomes to a seed investment and much to consider, such as long-termfund-raising goals and strategic plans. Entrepreneurs, whatdo you prefer, non-interest bearing simple agreements for futureequity? "SAFEs" over traditional interest-bearingconvertible notes?

Startups generally raise money which is usually through one or acombination of the following avenues:

• Founder cash savings
• Selling goods or services
• University funding, grants orservices
• Obtaining non-dilutivegovernment or nonprofit grants
• Issuing common or preferredstock
• Incurring straight debt orconvertible debt
• Selling hybrid securities andwarrants

Convertible notes and SAFEs fall into the last category, withsome characteristics of both equity and debt.

A SAFE is a "simple agreement for future equity."Don't think of it as equity, and it's not debt. Thinkof it as a warrant. The SAFE was created by a creative teamof lawyers working for the Y Combinator accelerator program in theSan Francisco Bay Area to simplify seed stage funding for startups with a catchyacronym. While ubiquitous in northern California, companiesusing the SAFE structure can be found all over the world. The SAFE,revamped in 2018, is being used more and remaining outstanding ingreater duration, as companies navigate the pre-Series A waters forlonger to get to a meaningful equity round.

Convertible notes and SAFEs

Convertible notes and SAFEs are defined as agreements takingplace between a company and an investor to exchange shares in thefuture for funds today. The instruments function as follows: Aninvestor gives the company cash now and receives the right at afuture point in time, to convert that money into company stock,commonly at a significantly better rate than the investor wouldreceive if they purchased stock from the company directlylater.

Think of the SAFE as a convertible note with the event ofdefault, interest, and maturity date provisions stripped out. Theycome in several forms, with the primary differences between thembeing interest and maturity.

• Interest—Founders like the SAFEbecause no interest accrues. Investors thus prefer them. SAFEs arenot a debt instrument. Because SAFEs are not interest-bearing, yousave a little dilution. Convertible notes can carry an interestrate in the range of 2% to 8%. The longer the notes remainunconverted, the more interest accrues, which keeps thefounder's feet to the fire to convert them quicker by raisingmore money and faster.

• Lack of maturity date— A SAFEhas an infinite duration, so they convert only when there is anopportunity to do so. A convertible note typically has a maturitydate of between 12 to 24 months. At some point, convertiblenotes have to be dealt with, so that founders are accountable toinvestors. Generally, this happens near maturity when everyoneunderstands what the plan is. The mathematical calculations inconvertible notes upon conversion can be quite complicated(discount plus interest). They can be easily misunderstood.

• No event of default – becausethe SAFE is not a promise to pay back cash, there are no events ofdefault. Combine this with no maturity date, and a SAFEinvestor can't foreclose on a company and take it over. On theflip side—SAFEs bring more uncertainty for investors. A SAFEwith no maturity date allows the founder to continue offering SAFEsand avoid converting, and indefinitely delaying the "what isthe plan?" discussion.

• Ease of documenting – Oneof the purported advantages of the SAFE is that a short documentdocuments it. A convertible note is typically recorded by multipleagreements, starting with a term sheet and then a purchaseagreement, note, and voting agreement.

The logic for using convertible notes or SAFEs to amasscash—as opposed to taking on straight commercial debt orundertaking a traditional equity financing—is simple.

The shortcoming with traditional debt is that it is satisfiedsolely by the company giving the lender cash when the maturity datearrives, which can create problems for early-stage companieswithout a predictable flow of money. When the debt falls due, astartup without sufficient funds on hand may be forced to raisemore funds via convertible notes, by the issuance of SAFEs, througha conventional equity financing, or by accumulating more debt topay off prior lenders, or worse yet, a lender could foreclose uponthe company's assets. These means of obtaining money diverttime and energy from the company's main business and canthemselves accrue additional hefty expenses. Convertible notes andSAFEs circumvent these difficulties by allowing the debt to berepaid via the conversion of the invested sum into shares,conserving cash on hand.

A traditional equity financing forces a company to set avaluation at the worst possible timeThis is particularlychallenging for early-stage pre-revenue companies that have littlebasis upon which to ascribe a positive valuation, much less marketfit for the product. Convertible notes and SAFEs avoid thisobstacle by facilitating the give-and-take of cash for shares inthe future, effectively punting the valuation down the line to thetime of a traditional equity financing—when the company islikely to have a resilient basis upon which to establish a positivevaluation. Another benefit that convertible notes and SAFEsconvey—in contrast to traditional equity financing—isthat they do not require ceding any portion of company control tothe investor at the time that the money is given. This effectivelybuys the company more time, perhaps a few more years, to developwithout having the investor in the boardroom.

What we've seen in recent years

Series A rounds have become larger and with rising goalposts toget to Series A, also tightening, which is why we see companiesstaying in the seed and pre-seed stage for more extendedperiods. To stay alive, pre-seed and seed stage companieshave to raise multiple rounds of seed capital. As the runwayextends, investors have to hold on for longer until conversion toshares.

In response to this phenomenon, Y Combinator released new formsof SAFE in Q4 of 2018 with two fundamental changes:

1. Valuation is measuredpost-money instead of pre-money
2. Removing pro rata rights to participate in futurerounds

There are multiple versions of the SAFE available on YCombinator's site, to address whether or not the instrumentwill include a cap on conversion, a discount to equity valuationupon conversion, with other versions including neither andboth.

Outlook: Seed financing in 2020

With Series A deals happening later and later, and at larger andlarger sizes, we believe that the SAFE and the convertible notewill continue to be used by companies for seed and growth capital,not just for startups, and for longer periods. As we assessthe market correction that is happening in March 2020, this trendcould deepen.

Pro-investor or pro-founder terms will ebb and flow with theamount of capital available, investor sentiment, public companycomparable valuations and multiples. As we wrap up Q1 in2020, we are seeing a new focus on proving out the business model,the market fit, and potential future profitability before companiescan get to Series A, and we expect further innovation in seed stagefinancing instruments to evolve in response.

Obligatory COVID19 update

If you are a company that has raised equity capital and in acash crunch, we advise to take this opportunity to review your cashburn and make some hard decisions that you have beendelaying. If considering whether to take a bridge convertiblenote, consider that an extension round on your existing series ofpreferred could be a much better deal. Convertible notediscounts on future conversion and interest could be very expensivemoney. If you are worried about dilution to the common,consider whether it's appropriate for key members of themanagement team to receive equity grants struck at the post-money409A value to keep incentives aligned.

Final plug: Whether you're the company or theinvestor, always consult legal counsel to verify that the termsof any convertible note or SAFE are fully understood and agreedupon by all parties involved.

Originally published by Law Insider on the 19th of May,2020.

The content of this article is intended to provide a generalguide to the subject matter. Specialist advice should be soughtabout your specific circ*mstances.

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