What are convertible notes and SAFEs and what are the major differences?

Takeaway: Convertible notes and SAFEs are both great ways to raise capital. The primary difference is that convertible notes are technically debt (i.e., the mature and can be called) and carry interest whereas SAFEs typically can’t be called and don’t carry interest. SAFEs are generally a better instrument from a company’s perspective.

When early-stage startups are looking for a way to raise capital, they often turn to convertible notes and Simple Agreement for Future Equity (SAFE) as investment options. These financial instruments can help startups receive investment funds more quickly and easily than through a traditional preferred stock financing. However, while both are instruments that convert into equity, there are significant differences between the two.

Convertible Notes

Convertible notes are a type of debt that converts into equity at a later date, often when the company raises a certain amount of funding. Investors who purchase convertible notes usually receive (i) a discount off the purchase price of the stock sold in the subsequent preferred stock financing, (ii) a valuation cap, which is intended to protect the investor against the company raising a preferred stock financing at a very high valuation, or (iii) both a discount and a valuation cap. Convertible notes usually include a maturity date at which the note must be repaid with interest if it has not already converted into equity.

Simple Agreements for Future Equity (SAFEs)

SAFEs are similar to convertible notes in that they allow investors to invest in a company with the expectation of future equity. However, unlike convertible notes, SAFEs do not accrue interest and do not have a maturity date. Instead, investors receive equity in the company at a future date when a specified event occurs, such as a later funding round or the company’s sale.

For many years, convertible notes were the go-to structure for early-stage fundraising. Companies were attracted to their ease of use and simplicity. Investors liked them for the same reasons and also because they received interest and were technically creditors of the company. SAFEs were first introduced by Y Combinator in late 2013 as a simpler alternative to convertible notes for early-stage startup funding. Since then, SAFEs have become a popular method of fundraising for startups, probably outpacing convertible notes in terms of use.

Conclusion

Overall, the choice between convertible notes and SAFEs will depend on the specific needs and goals of the startup and its investors. While both offer benefits and drawbacks, they can provide a valuable way for startups to raise capital and grow their business.