When should I use convertible notes and SAFEs?

Takeaway: Convertible notes and SAFEs can be beneficial for early-stage startups that require quick funding and cost-efficiency, and when precise valuation is challenging. However, their simplicity could lead to potential dilution in future equity rounds, emphasizing the importance of understanding these financing mechanisms and seeking appropriate advice.

Fundraising is a critical aspect of establishing and growing a startup, and each startup's journey is unique. When it comes to early-stage financing, founders often grapple with deciding between convertible notes, Simple Agreements for Future Equity (SAFEs), and preferred stock financings. In this post, we'll focus on situations when choosing convertible notes or SAFEs could be more beneficial for startups over preferred stock financing.

Stage of Your Startup

Convertible notes and SAFEs are particularly appealing for early-stage or seed-stage startups. One of the main reasons for this is the difficulty in accurately valuing a young company. Both convertible notes and SAFEs cleverly circumvent this problem by deferring the valuation of the company to a later financing round, ideally when the startup is more mature, and its value is easier to ascertain.

Speed and Cost Efficiency

When a startup needs to secure funds promptly and minimize legal costs, convertible notes and SAFEs emerge as ideal options. Compared to preferred stock financing, these instruments typically involve less time-consuming negotiations and require simpler documentation. This results in a quicker, more cost-effective fundraising process.

Investor Dynamics

The investor-startup relationship is a significant factor to consider. Convertible notes and SAFEs are often more straightforward to negotiate due to their simplicity and fewer terms. However, remember that investors' preferences may vary. Some sophisticated investors might prefer preferred stock financing, which offers them more protection.

Conclusion

Like all financial instruments, convertible notes and SAFEs come with their own drawbacks. A key one is the potential for significant founder dilution in the future equity round when these instruments convert into equity. It is vital to understand these financing instruments and their implications fully. Always seek appropriate legal and financial counsel to guide your startup through this complex terrain. Each startup's best choice will depend on its unique circumstances, goals, and the particular dynamics of its investor relationships.

If you’re looking for more information on how to decide when to use convertible notes/SAFEs and when to raise a priced equity round, take a look at this YC interview.