Should I use a convertible note or a SAFE?
Takeaway: Companies should generally prefer to use a SAFE over a convertible note because the SAFE is not debt (it cannot be called at maturity) and does not accrue interest.
When it comes to raising capital for startups, there are several options available, including convertible notes and SAFEs (Simple Agreements for Future Equity). Both of these financing tools are used by startups to raise capital in their early stages of growth. I usually recommend startups push to use SAFEs over convertible notes for a couple reasons:
SAFEs are (at least according to many people) not debt and, as a result, investors that purchase SAFEs from a startup are not creditors. This is important because creditors have certain rights under the law that SAFE holders do not. This can get tricky with startups because they often operate with little in the way of assets and can quickly become technically insolvent.
Convertible notes accrue interest while SAFEs do not. This means that when convertible notes convert into equity, they will convert into more shares (all else being equal) than SAFEs.
Customary convertible notes and SAFEs have identical conversion mechanisms, meaning that they both automatically convert into equity upon the company’s next preferred stock financing. In addition, there is usually a minimum amount that the company has to raise in order to automatically convert convertible notes and SAFEs. Some convertible notes and SAFEs also have voluntary conversion features, which permit (but do not require) the investor to convert in financings that do not raise a minimum dollar amount. Both convertible notes and SAFEs also customarily either convert or are paid a minimum amount in an acquisition.
So, which one should startups use? Generally, companies should prefer to use SAFEs for the reasons outlined above. Investors, however, typically prefer using convertible notes so, in practice, some fundraising is done on SAFEs and some is done on convertible notes. Ultimately, it is important for startups to consider all of their options and work with legal and financial advisors to determine which financing tool is best suited for their particular needs.