During the seed round of a business, a founder may struggle to obtain funding as during this phase the company may not have profits or revenue, making it very difficult to establish a reasonable valuation. This is where financing methods like SAFEs and convertible notes give startups a way to funding without a valuation or giving up equity in the initial stages of the company.
As a founder, you may be wondering how to choose between SAFE or convertible notes for your startup. Pre-SAFE (pre-money) notes are diluted by all funding and notes that occur before the maturity date. Post-SAFE (post-money) notes are only diluted by the funding round that triggers conversion. Pre-SAFE notes lead to less dilution for the founders and more dilution for the note holders while Post-SAFE notes lead to the opposite. Pre-SAFE notes are more difficult to calculate ownership when there are more investors and notes compared to Post-SAFE notes. In general, the reason to go with a note is a shorter time period to receive seed funding and lower associated cost, though the cost of a priced equity round has come down.
SAFE Notes (Simple Agreement for Future Equity) are agreements that allow for an investor to invest money in a company for future equity, usually when a triggering event occurs, rather than having a priced round with a valuation placed on the company at the time of investment. SAFE notes can have either a cap or discount but more commonly they will have both to calculate the equity of the note holder when there is a priced round (generally Series A which for simplicity I’ll use for the rest of the post). The note will convert to equity at the time of Series A investment and the note converts at the lower per share price at either the valuation cap or the discount rate applied to the Series A share price.
Convertible Notes are a debt instrument that convert into equity at either a qualifying event or at the maturity date. In short, they are loan agreements that accrue interest and convert into equity after a maturity date or triggering event. the company has the option to pay off the convertible debt with equity after a conversion event. Their conversion is pre-money so they will be diluted by other notes and other funding pre-Series A. Though it is rare for a convertible note to be repaid at the maturity date and are generally extended.
In conclusion, understanding the nuances of Pre-Safe, Post-Safe, and Convertible Notes is essential for both startups and investors. Safe notes provide simplicity and flexibility, while convertible notes offer more structured terms. Each option has its own set of advantages and disadvantages, making it crucial to weigh the specific needs and risk tolerance of your unique situation. Ultimately, the choice between these financing instruments should align with your business goals and priorities, ensuring a smoother path to growth and success.
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