One of the main issues that startups face is the best way to raise capital. Startups raise capital so that they can turn their ideas into functioning products or services. Following that, you will often have to convince investors why they should invest in a particular startup. In addition to a straight equity round, you can choose from two other possible structures for an equity capital raise: a convertible note or a simple agreement for future equity (SAFE). This article will explain what these two instruments are and the main differences between them.
What is a SAFE?
A simple agreement for future equity (SAFE) is a type of instrument that startups can use to raise capital. Essentially, an investor will provide seed money to a business. In return, they will have a right to receive equity in the startup in the future when a predetermined trigger event occurs. Trigger events are typically a priced equity raise or a liquidation event.
The number of shares the investor will receive links to the cash injection they make and the share price of the priced round or liquidation event. Often, you may give them a discount to reward them for their early commitment to the startup. As a result, they end up receiving more shares than they would otherwise.
Benefits of SAFE
One main advantage of a SAFE are that they do not have a term. Therefore, if the trigger event never occurs, the investor will never receive shares. Additionally, they do not incur interest. As a result, SAFEs are more straightforward than convertible notes. They are a great way of getting an injection of money into your startup quickly.
Continue reading this article below the formWhat is a Convertible Note?
A convertible note is a hybrid of debt and equity. It allows an investor to loan funds to the startup. That loan then converts into equity in the future on a predetermined trigger event (of a similar nature to SAFEs). Again, the conversion rate is calculated by reference to the share price of the priced round or liquidity. A discount may also apply.
Initially, the note acts as debt, and there is an interest rate and maturity date negotiated between the parties. Often, businesses may issue convertible notes if they are unable to get a loan from a traditional financial institution due to a low credit rating but still have a high potential for growth.
Benefits of a Convertible Note
The main benefit of a convertible note is that it protects an investor’s downside through regular interest payments, but with the advantage of a later conversion of debt into equity. Another benefit of a convertible note is that it can delay having to value a startup. It can often be difficult to value businesses at the start of their life cycle as there is little data to go off. Issuing a convertible note means that the business only has to be valued at the first round of seed funding when there is often sales data that you can rely on.
Difference between a Convertible Note and a SAFE Note
The fundamental difference between these two instruments is that a SAFE is often a simpler arrangement than a convertible note due to no interest rate or maturity date applying. For many businesses, a SAFE is a more attractive option as it does not sit on the books as debt.
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Key Takeaways
Raising money can be a difficult task for startups as founders must convince investors that they should invest in their businesses. You can usually raise money through a variety of instruments. Two methods available to you are SAFEs and convertible notes. SAFEs are a recent innovation that allows investors to provide money to a business in exchange for equity at a certain point in the future. These are attractive to companies raising money as they are more straightforward and do not incur interest. Convertible notes are a hybrid instrument where a business receives a loan from an investor that you can turn into equity at a later date. These are more attractive to investors as it creates an upside while protecting their downside.
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Frequently Asked Questions
SAFEs are often converted into the same class of share as issued under the priced round that triggers conversion of the SAFE. Depending on the price round, this often means preferred shares are issued.
Yes, convertible notes are converted into shares on a pre-agreed trigger event which is usually a priced round or liquidation event.
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