Understanding Convertible Notes and SAFEs in Seed Funding

Understanding Convertible Notes and SAFEs in Seed Funding

Seed funding is the initial investment made by investors to a startup or a company, before it is ready for a more substantial round of funding. Seed funding is the most basic form of raising capital for a company, and it is usually provided by angel investors or venture capitalists (VCs). These investors help in providing the required financial resources a company needs to jumpstart its operations towards growth.

In seed funding, various financing options are available, such as equity crowdfunding, seed funding, and convertible notes, among others. Among these options, convertible notes and SAFE (Simple Agreement for Future Equity) offer an opportunity to access seed funding with flexible terms and conditions. In this article, we will discuss convertible notes and SAFE as crucial seed funding options.

What is a Convertible Note?

A convertible note is a type of loan agreement that converts into equity, typically during the company’s next financing round. Investors provide seed funding to the startup as a loan, with an attractive interest rate, a maturity date, and a trigger for conversion to equity. Generally, the terms of convertible notes are simple and straightforward, enabling startups or companies to access seed funding without complex rules or commitments.

The primary advantage of convertible notes is that the company’s founders can delay setting a valuation in the early stages. It enables the startup to focus on building and developing the business, and after a meaningful valuation is established, the loan can convert into equity. Until then, the investors receive a fixed interest rate and have priority over other equity investors.

What is SAFE?

SAFE is a contract between the investors and a company that provides seed funding for the company in exchange for a future equity stake. Unlike convertible notes, SAFE does not involve a loan agreement. Instead, it is a warrant that can be converted into equity or liquidated if specific triggering events occur.

SAFE typically has straightforward terms and conditions, which are beneficial for both the company and investors. It includes features such as conversion discount or valuation cap, which reduces the dilution risk for investors, while allowing the startup to obtain seed money without fear of immediate repayment.

Key Differences between Convertible Notes and SAFEs

  • Interest rates: Convertible notes typically carry a fixed interest rate, whereas SAFEs do not involve loans and do not provide interest rates.

  • Repayment: Convertible notes are debt, and they must be repaid once they mature, whereas investors take equity stakes in the company via SAFE.

  • Conversion process: Convertible notes convert into equity automatically, whereas SAFEs require specific conditions or triggering events to do so.

  • Price Valuation: Convertible notes can be converted into equity at a discount rate over the next round of financing, whereas SAFEs can have a valuation cap or discount rate based on the company’s financial performance at the time of conversion.

Conclusion

Convertible notes and SAFEs are crucial and popular options for startups to secure seed funding. The decision to choose either of these options should be among the company founders, based on the individual company’s financial status, growth potential, and business model. Convertible notes enable entrepreneurs to avoid immediate valuation, while SAFEs provide seed funding from investors without taking on debt. Whatever the option chosen, it is important to have an expert attorney to review the agreements’ terms and conditions and address any critical legal issues.

So, entrepreneurs should consider whether they want to opt for a convertible note or a SAFE while aiming to secure their seed funding.