PRE-SAFE, POST-SAFE,
AND CONVERTIBLE NOTES
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.
what are safe notes?
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.
Pre-SAFE vs Post-SAFE
What are convertible notes?
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.
Pre-SAFE Note
PROS
- Flexibility – Pre-SAFE notes can be tailored to meet the specific needs and circumstances of the startup and its investors, allowing for greater flexibility in terms, conditions, and conversion triggers.
- Customization – Parties can negotiate and agree upon terms that are more favorable or tailored to their individual preferences.
- Investor-Friendly –Â Pre-SAFE notes may offer more investor-friendly terms compared to a standard SAFE, potentially attracting a wider range of investors.
- Early-Stage Funding – Â They can provide a vehicle for raising funds at a very early stage.
- Simplicity – Depending on how it’s structured, a pre-SAFE note might be simpler to understand and implement than other complex financing instruments.
CONS
- Legal Complexity – The customization that makes pre-SAFE notes flexible can also make them legally complex.Â
- Uncertainty – The lack of standardization in pre-SAFE notes can lead to uncertainty and ambiguity for both startups and investors.
- Limited Adoption – Pre-SAFE notes are not as widely recognized or understood as standard SAFEs, which can limit their appeal to investors.
- Potential for Disagreements –Â The flexibility of pre-SAFE notes can lead to disputes between founders and investors if expectations and terms are not clearly defined or if there is a change in the startup’s circumstances.
- Dilution –Â Like SAFEs, pre-SAFE notes can lead to dilution of the ownership stake of founders and early investors if conversion events occur at a later stage.
POST-SAFE Note
PROS
- Continued Funding –Â Post-SAFE financing can provide startups with additional capital to fuel their growth after the initial SAFE round, allowing them to achieve important milestones and reach the next stage of development.
- Valuation Clarity –Â By the time a post-SAFE financing round occurs, the startup may have a clearer valuation, making it easier for investors to assess the company’s worth and negotiate terms.
- Diversification –Â Startups can bring in a diverse set of investors, including venture capitalists (VCs), angel investors, or strategic partners, through post-SAFE financing rounds, which can provide valuable expertise, connections, and resources.
- Bridge Financing –Â In cases where the startup is not yet ready for a traditional equity round (e.g., a priced equity round), post-SAFE financing can serve as bridge financing to sustain operations until more significant milestones are achieved.
- Customization –Â Post-SAFE financing agreements can be customized to meet the specific needs and objectives of the startup and its investors, allowing for flexibility in terms and conditions.
CONS
- Dilution –Â Like any form of equity financing, post-SAFE financing can result in dilution of the ownership stake of existing shareholders, including founders and early investors.
- Negotiation Complexity –Â Negotiating post-SAFE financing agreements can be complex, involving multiple parties with varying interests and preferences. This complexity can lead to protracted negotiations.
- Information Sharing – Investors in post-SAFE rounds may require more detailed financial and operational information from the startup, which could potentially limit the startup’s ability to keep certain information confidential.
- Potential Investor Conflicts – Bringing in new investors through post-SAFE financing rounds can lead to conflicts of interest or disagreements among different investor groups, particularly if they have varying expectations or investment horizons.
- Conversion Terms –Â The conversion terms from SAFE to post-SAFE financing may be subject to negotiation, potentially leading to disputes between investors and founders if not well-defined.
Convertible Note
PROS
- Speed and Simplicity: Convertible notes are often quicker and simpler to set up compared to equity rounds, as they typically involve fewer negotiations and legal documentation.
- Deferred Valuation: Convertible notes allow startups to postpone determining the valuation of the company until a later equity financing round. This can be advantageous when the company’s value is uncertain or rapidly changing.
- Attracts Early-Stage Investors: Convertible notes are attractive to angel investors and early-stage venture capitalists who may not have the expertise or resources to negotiate a valuation for the startup.
- Debt Structure: Convertible notes are considered debt, so they don’t immediately dilute the ownership of existing shareholders, including founders.
- Interest Rate: Convertible notes may accrue interest over time, providing an incentive for investors to convert the notes into equity sooner rather than later.
- Conversion Discount: Convertible notes often include a conversion discount, which rewards early investors by allowing them to convert their debt into equity at a lower price per share than later investors in an equity financing round.
CONS
- Uncertainty: Convertible notes introduce uncertainty regarding the future ownership percentage and dilution for both founders and investors. The final equity ownership depends on the valuation and terms of the future equity financing round.
- Interest Costs: While the interest rate on convertible notes can incentivize early conversion, it also means the startup has to make interest payments, which can be a financial burden.
- Complexity: While convertible notes are simpler than equity rounds, they still involve legal documentation and can be complex to structure, particularly when multiple convertible note rounds stack up.
- Cap Table Management: As convertible notes convert into equity, they can complicate the startup’s cap table, potentially creating many small equity holders.
- Conversion Trigger: The timing and terms of conversion can vary, leading to potential disagreements between investors and founders if the triggering event is not well-defined.
- Default Risk: If the startup fails to secure an equity financing round or reach a triggering event, the convertible notes may mature and become due for repayment, potentially straining the startup’s finances.
- Lack of Control: Investors in convertible notes do not typically have voting rights, which means founders maintain control over major company decisions until conversion.
conclusion
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.
Finvisor’s expert team can help you with this decision, contact us todayÂ
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