Convertibles and SAFEs for startups: a 2024 guide

Not every investment in a startup leads to a new company valuation. SAFEs and convertible notes are two other ways companies can raise money without having to set a new share price.

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SAFEs give investors the right to equity in a future funding round, while convertible notes are loans that can later turn into shares. Both are popular with early-stage startups, especially those that don't yet have a solid business model for investors to set the value confidently or are in a market that is on track to get better. We will take a closer look at both options.

Convertible Notes

Convertible notes are a popular way for new companies to raise money without worrying about their value or giving up equity immediately. If done right, they have proven to work well for both startups and investors.

📖 Convertible notes are favoured in seed to early-stage fundraising rounds.

What are convertibles?

Convertible notes, also called promissory notes, convertible loan agreements, convertibles, or convertible debts, are a form of short-term debt with an interest rate issued by the investor to the startup that is either paid back at the maturity date or converted into equity at the trigger events.

How does Convertible Note Work?

Initially, parties agree in writing that an investor lends money to the startup in exchange for a convertible note. The loan bears yearly interest and has a maturity date to which the startup either repays the loan and accrued interest or converts it into equity at the investor's discretion if there have not been any trigger events before the maturity date.

📖 On average, interest rates range from 4% to 10%, and loans are issued for a term of 2 to 5 years.

Convertible notes may have trigger events before maturity date such as a new qualified financing round or qualifying events (e.g. acquisition).

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If the trigger event happens, then the startup, instead of repaying the loan and the accrued interest, shall convert it into equity (shares) in the company before or during the next financing round, with or without a discount rate.
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📖 Discounts range from 0% to as high as 35%, with 20% being common.

The conversion may have different scenarios, which we will try to illustrate further, but before it, there are key clauses of convertible notes that you should be aware of.

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What are the Key Clauses of Convertible Notes?

1. Discount Rate: This is a percentage discount on the price per share paid by new investors during the trigger event. For example, if new investors pay €1 per share, a 20% discount rate would allow the note holders to convert their debt into equity at €0.80 per share.
2. Valuation Cap: This is the maximum valuation at which the note can convert into equity, regardless of the company's valuation during the trigger event. It protects early investors from excessive dilution if the company’s valuation soars.
3. Interest Rate: Convertible notes usually accrue interest over time. Upon conversion, the accrued interest is also converted into equity.
4. Maturity Date: This is the date by which the company must repay the note if it hasn’t yet converted to equity. If the note is not converted by this date, it may be renegotiated, converted into equity, or repaid.
5. Qualified Financing Round: This is a specified fundraising event where the company raises a significant amount of capital, as defined in the terms of the convertible note. When this round happens, it triggers the conversion of the convertible note into equity. The qualified financing round ensures that the note converts to shares when the company has raised enough funds to have a more precise valuation.
6. MFN (Most Favored Nation) Clause: This provision ensures that if the company issues convertible notes or similar instruments in the future with more favourable terms, the existing investors can opt to adjust their terms to match those better terms. This protects early investors by ensuring they are not disadvantaged compared to later investors.

How do you convert Convertible Notes into equity?

Understanding how convertible notes convert into equity is essential for accurately representing them in a cap table.

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1. Simple Convertible Note

📖 Key details:
Convertible Note Loan Amount: €500’000
‍Interest Rate: 5% annually
‍Maturity Date: 2 years
‍Conversion Trigger: Series A funding round
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Series A funding round details:
Series A valuation is €10 million,
the company will have 1’000’000 shares.

‍Explained:

The company raises  €500’000 with a simple convertible note. This means the loan and accrued interest for two years will convert into equity at the same price as other Series A investors, with no special terms to benefit the note holders.

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Calculation:

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1. The accrued interest amount is €50,000, which is €500’000 x 5% x 2 years.
2. Total amount to convert is €550’000, which is €500’000 (principal) + €50,000 (interest).
3. Series A share price will be €10 per share = €10’000’000 / 1’000’000 shares.
4. The investor gets 55'000 shares from conversion, which is €550’000 / €10 per share.

💡 Outcome: The €500’000 convertible note and accrued interest of € 50’000 converts into 55’000 shares at the Series A share price of €10.

2.Convertible Note with Valuation Cap

📖 Key details:
‍Same as above and in addition:
‍Valuation Cap: €4 million

Explained:

The company raises €500’000 with a convertible note that has a valuation cap of €4 million.

This cap means that when the loan and accrued interest for two years convert into shares, it will do so as if the company valuation were €4 million, no matter what the actual valuation is during the Series A round.

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Calculation:

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1. The accrued interest amount is €50,000, which is €500’000 x 5% x 2 years.
2. Total amount to convert is €550’000, which is €500’000 (principal) + €50,000 (interest).
3. Series A share price will be €10 per share = €10’000’000 / 1’000’000 shares.
4. Conversion share price with a €4 million valuation cap is calculated as if the company were valued at €4 million. The capped valuation of €4 million means shares are issued at a lower price. If 1 million shares are issued at €10 million, each share would cost €10. With the €4 million cap, each share will cost €4, which is €4’000’000 / 1’000’000 shares.
5. Conversion results in 137’500 shares which is €550’000 / €4 per share.

💡 Outcome: The €500’000 convertible note and accrued interest of €50'000 converts into 137’500 shares at the capped valuation price of €4 per share, thanks to the valuation cap, which benefits the investor by providing a lower conversion price compared to the actual Series A share price of €10.

3. Convertible note with Valuation Cap and Discount

‍📖 Key details:
‍Same as above and in addition:
‍Valuation Cap: €4 million
‍Discount: 20%

Explained:

The company raises €500’000 with a convertible note that has a valuation cap of €4 million and a 20% discount on the next funding round share price.

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When a convertible note has both a discount and a cap, it will usually state that the conversion price will be whichever is lower: the price per share using the discount or the price per share using the cap. The lower price per share is better for the investor because it means they get more shares when the note converts into equity during the next funding round.

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Calculation:

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1. The accrued interest amount is €50,000, which is €500’000 x 5% x 2 years.
2. Total amount to convert is €550’000, which is €500’000 (principal) + €50,000 (interest).
3. Series A share price will be €10 per share = €10’000’000 / 1’000’000 shares.
4. The lowest price:
   
   • Share price with a €4 million valuation cap is calculated as if the company were valued at €4 million. The capped valuation of €4 million means shares are issued at a lower price. If 1 million shares are issued at €10 million, each share would cost €10. With the €4 million cap, each share will cost €4, which is €4’000’000 / 1’000’000 shares
   • Share Price with Discount: €10 x (1 - 20%) = €10 x 0.8 = €8 per share
   The notes will convert at the lowest price between these two, and this time, the lowest is the share price with the valuation cap, as it costs €4 per share compared to the share price with the discount, which costs €8 per share.‍
5. Conversion results in 137’500 shares which is €550’000 / €4 per share.

💡 Outcome: The €500’000 convertible note and accrued interest of €50'000 converted into 137’500 shares at the capped valuation price of €4 per share, which was lower than the share price with a discount.

SAFEs

What are SAFEs?

A SAFE (Simple Agreement for Future Equity) is a financial instrument introduced by Y Combinator, the renowned startup accelerator, in late 2013. It was created to help early-stage startups and seed investors raise capital swiftly and easily. Y Combinator provides drafts for three versions of SAFEs. Beyond the Y Combinator community, SAFEs have gained immense popularity in the startup ecosystem due to their founder-friendly terms, simplicity, and efficiency. However, over time, investors and founders occasionally amend terms in SAFEs, and we see all kinds of new versions of SAFEs that are not always founder-friendly.

📖 SAFEs are favoured in pre-seed and seed fundraising stages.

How do SAFEs Work?

A SAFE is a contract that grants investors the right to receive equity in the company at a future date, usually during the next financing round.

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SAFEs convert into equity (shares) when a triggering event occurs, typically the next equity financing round. The conversion terms are predefined in the SAFE agreement.

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SAFEs do not require the company to repay the initial investment, nor does it bear any interest rates or have a maturity date.

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What are the Key Clauses of SAFEs?

1. Discount Rate: This is a percentage discount on the price per share paid by new investors during the trigger event. For example, if new investors pay €1 per share, a 20% discount rate would allow the note holders to convert their debt into equity at €0.80 per share.
2. Valuation Cap: This is the maximum valuation at which the SAFE can convert into equity, regardless of the company's valuation during the trigger event. It protects early investors from excessive dilution if the company’s valuation soars.
3. Qualified Financing Round: This is a specified fundraising event where the company raises a significant amount of capital, as defined in the terms of the SAFE. When this round happens, it triggers the conversion of the SAFE into equity. The qualified financing round ensures that the SAFE converts to shares when the company has raised enough funds to have a clearer valuation.
4. Pro Rata Rights: Grants investors the right to participate in future financing rounds to maintain their ownership percentage.
5. MFN (Most Favoured Nation) Clause: This provision ensures that if the company issues convertible notes, SAFEs or similar instruments in the future with more favourable terms, the existing investors can opt to adjust their terms to match those better terms. This protects early investors by ensuring they are not disadvantaged compared to later investors.

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What type of SAFEs are there?

Y Combinator has changed over time drafts of SAFEs they provide, but these will be the most commonly seen within the startup scene:

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1. SAFE (Valuation Cap, No Discount) includes a valuation cap but does not provide a discount on the price per share in the future equity round.
2. SAFE (Valuation Cap and Discount) includes both a valuation cap and a discount on the future equity round's price per share.
3. SAFE (No Valuation Cap, Discount) includes only a discount on the price per share in the future equity round, with no valuation cap.
4. SAFE (MFN, No Valuation Cap, No Discount) includes a "most favoured nation" clause, meaning if the company issues a better SAFE in the future, the terms of this SAFE will automatically adjust to match those better terms. It has no valuation cap and no discount.

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In addition to that, Y Combinator provides a Quick Start Guide on SAFEs.

How do you convert SAFE into equity?

Understanding how SAFEs convert into equity is essential for accurately representing them in a cap table.

📖 Key details:
Investment Amount: €100,000
‍Valuation Cap: €5 million
‍Next Funding Round Valuation: €10 million
‍Number of Series A Shares: 1 million
‍Series A Share Price: €10 per share (€10 million / 1 million shares)

1. SAFE (Valuation Cap, No Discount)
   • Valuation Cap Price per Share: €5 per share (€5 million / 1 million shares)
   • Shares Issued: €100’000 / €5 per share = 20’000 shares
2. Explained: The SAFE investor invests €100’000 with a valuation cap of €5 million. When the company undergoes the Series A round with a €10 million valuation, resulting in a share price of €10, the valuation cap of €5 million limits the maximum price per share the investor will pay resulting to €5 per share.
3. SAFE (Valuation Cap and Discount)
   • Valuation Cap Price per Share: €5 per share (€5 million / 1 million shares)
   • Discounted Share Price: €8 per share (€10 per share * 80%)
   • Lower of the Two Prices: €5 per share (valuation cap price is lower)
   • Shares Issued: €100’000 / €5 per share = 20’000 shares
4. Explained: The SAFE investor invests €100,000 with a valuation cap of €5 million and a discount of 20% on the next round’s share price. During the Series A funding round, the company is valued at €10 million, resulting in a share price of €10 per share. The investor can convert their SAFE at either the discounted share price (€8 per share) or the valuation cap price (€5 per share), whichever is lower.
5. Since €5 per share (valuation cap price) is lower than €8 per share (discounted share price), the SAFE converts at €5 per share.
6. SAFE (No Valuation Cap, Discount)
   • Discounted Share Price: €8 per share (€10 per share x (1-20%))
   • Shares Issued: €100’000 / €8 per share = 12’500 shares
7. Explained: The SAFE investor invests €100,000 with no valuation cap but receives a 20% discount on the next funding round’s share price. During the Series A round, the company is valued at €10 million, resulting in a share price of €10 per share. Applying the 20% discount reduces the share price to €8 per share.
8. This means the investor benefits from the discount, receiving more shares than they would have at the full Series A share price.
9. SAFE (MFN, No Valuation Cap, No Discount)
   • Potential Adjustment: If future investors receive better terms, SAFE's terms adjust to match those.
   • Shares Issued: €100’000 / €10 per share = 10’000 shares
10. Explained: The investor is putting in €100,000 under a SAFE agreement. There is no valuation cap in this scenario and no discount, which means that the shares will be priced the same as for the future investors in the Series A round, where the company is valued at €10 million, leading to a Series A share price of €10 per share.The MFN clause protects the investor. If future investors receive better terms than those provided to the initial SAFE investor, the terms of the initial SAFE will adjust to match the better terms. This ensures the initial investor is not disadvantaged by subsequent investments.

Why do startups and investors use SAFEs and Convertible Notes?

In regards to both SAFEs and convertible notes:

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• Quick and Simple Funding: SAFEs and convertible notes help founders raise money quickly and easily without setting a valuation, giving up control, or paying high legal fees.
• Short and Easy: These agreements are as short as a few pages, making them ideal for quick deals.
• Flexible Timing: Founders can arrange funding rounds more flexibly rather than forcing investors into a single deadline.
• Deferred Negotiations: Detailed terms like board seats, company valuation and other time-consuming details can be worked out during the next funding round.

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In regards to the SAFEs:

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• No Interest or Maturity Date: SAFEs don’t earn interest and don’t have a set end date. They turn into shares during the next funding round, merger, or sale and dilute less than convertible notes.

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In regards to the convertible notes:

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• Debt Priority: In case of a company shut-down or failure, convertible notes, which are a form of debt, typically have priority over equity in the order of repayment.

How do Convertible Notes and SAFEs compare to equity rounds?

How do the SAFEs and convertible notes differ? What is similar? And how do they compare to equity rounds?

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An equity financing round involves raising capital by selling company shares to investors. This process requires a company valuation to set the share price, which entails a thorough due diligence process to evaluate the company's financial health, business model, and growth potential.

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The sale of shares also requires legal compliance, including the proper documentation and transfer of shares, making it potentially time-consuming. This comprehensive approach ensures that both the company and the investors have a clear understanding of the company's value and growth prospects. Still, it also means that equity financing rounds tend to be more complex and costly compared to other funding methods like SAFEs or convertible notes.

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However, there is an evolving opinion that priced equity rounds may be a better choice as they do not create messy cap tables, unclear valuations, or accrued interest with higher dilution in the same way SAFEs and convertible notes do.

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We have created a table to make it easy to understand the key differences.

What are the predatory clauses of Convertible Notes or SAFEs to be aware of?

In regards to both convertible notes and SAFEs:

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1. Automatic Conversion at Unfavourable Terms — clauses that force conversion at terms that may not benefit the investor, such as a low valuation that leads to investors ending up with fewer shares than anticipated, reducing the value of their investment.
2. Mandatory Redemption - clauses that require the company to repay the investment under certain conditions, even if it might strain company finances, which can create cash flow issues.

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In regards to convertible notes:

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1. High Interest Rates - clauses that impose excessively high annual interest rates on the convertible note, which can lead to significant debt accumulation, burdening the company financially and disadvantaging the founders and early employees with more considerable dilution.
2. Penalties for Early Repayment - clauses that impose heavy penalties if the company repays the convertible note before a certain period, which limits the company’s flexibility in managing its finances.

Summary

SAFEs and convertible notes offer flexible, efficient, and founder-friendly alternatives to traditional equity financing. By allowing startups to defer complex valuations and detailed negotiations, these instruments enable quicker access to capital, fostering innovation and growth. However, startups should remember that although it is fairly easy to sign SAFEs or convertible notes, it's equally easy to mismanage cap tables without proper knowledge.

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Understanding the nuances of SAFEs and convertible notes, from their mechanics to their key clauses, is crucial for both startups and investors. Properly navigating these instruments ensures a fair and advantageous conversion process, essential for maintaining a clear and beneficial cap table.

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Ultimately, the choice between SAFEs, convertible notes, and equity financing depends on the startup's stage, the urgency of funding, and the long-term strategic goals of both founders and investors. Each funding method has its advantages and potential pitfalls, and understanding these can significantly impact the success and sustainability of the startup.