What are the major terms in convertible notes and SAFEs (e.g., discount and valuation cap)?
Takeaway: The major terms of convertible notes and SAFEs are the discount, valuation cap, amount of the next equity financing that triggers conversion, and the amount the investor receives in the event of an acquisition before the note/SAFE converts.
Convertible notes and Simple Agreements for Future Equity (SAFEs) are both popular investment instruments for startups. They are both designed to provide a relatively simple and quick way for startups to raise seed funding. In this post, we will explore the major terms of each instrument.
Convertible Notes
Convertible notes are essentially loans that can be converted into equity in the future. They typically have the following key terms:
Interest rate: Convertible notes may have an interest rate that accrues on the principal amount of the note. The interest rate is usually low (around 2-8%) because the investor is also receiving equity in the company and the intention is not that this actually function as a loan but instead that it essentially be a pre-funded equity investment.
Conversion discount: The conversion discount is the percentage discount that the investor will receive when converting the note into equity. For example, if the company's next funding round sets the share price at $1 per share and the conversion discount is 20%, the investor would receive shares at $0.80 per share.
Valuation cap: A valuation cap is a maximum valuation at which the investor's note can convert into equity. If the company is valued at a higher valuation in the future, the investor will convert their note into equity at the valuation cap instead of the higher valuation. This protects the investor from being diluted by the company raising at a really high valuation. The purpose of a valuation cap is to protect the investor, not to give them a windfall so they should be set at a valuation that the company expects to raise its next preferred stock financing at.
Conversion trigger: The conversion trigger is the event that triggers the conversion of the convertible note into equity. This is typically the company's next funding round or a liquidity event.
Maturity date: The maturity date is the date on which the note must be repaid if it has not already converted into equity. Sometimes convertible notes will have maturity conversion features where the investor can elect to convert its note into equity if the note has not converted automatically (e.g., in a financing) by the maturity date.
On the other hand, SAFEs are agreements that provide investors with the right to purchase equity in a company at a future date. They typically have the following key terms:
Valuation cap: Similar to convertible notes, SAFEs may have a valuation cap that determines the maximum valuation at which the investor can purchase equity in the future. As described above, this is designed to protect the investor and not to be a windfall. As a result, I typically counsel companies to set this at the valuation they expect to receive in their next preferred stock financing.
Discount rate: The discount rate is the percentage discount that the investor will receive when purchasing equity in the future. For example, if the discount rate is 20%, the investor would receive shares at a 20% discount to the future valuation. It functions the same as the discount in a convertible note.
Conversion trigger: This functions the same as a convertible note - the conversion trigger is the event that triggers the conversion of the SAFE into equity. This is typically the company's next funding round or a liquidity event.
Conclusion
Convertible notes and SAFEs both have their advantages and disadvantages for startups and investors. The key terms of each instrument should be carefully considered and negotiated to ensure that they align with the goals of the company and the expectations of the investor.