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Navigating Startup Funding Stages: Safe vs. Convertible Notes vs. Equity Rounds

 

Navigating Startup Funding Stages: SAFE vs. Convertible Notes vs. Equity Rounds

 

Whether you are a new or seasoned business owner, you probably have a clear understanding of the challenges involved with raising funding for a startup. Yet, startup funding and investing is vital for business owners.

When startup companies are in their early stages of growth, they are usually not self-sustaining or even profitable. So, business founders usually look to outside funding sources and investors. Yet, funding is not only important for early startups, as even seasoned companies may have the need for investors. This is why there are three funding options you may not be aware of: SAFEs, convertible notes, and equity rounds.

We have helped both early- and late-stage companies decipher which funding option is right for them, which is why we thought this month’s blog should detail each and then compare their pros and cons.

First, let’s give a quick overview of each one before we delve deeper:

  • SAFE (Simple Agreement for Future Equity): A “non-debt” investment agreement that promises the investor the right to receive future equity in the startup. “Non-debt” means it does not accrue interest or have a maturity date.
  • Convertible notes: A short-term debt instrument, similar to a business loan that includes interest and a maturity date, but instead of repaying the loan it automatically converts into equity after certain conditions have been met.
  • Equity Rounds:The process of selling company shares to investors for capital in the company at a fixed price, which is based on the company’s upfront valuation at that particular time.

 

Now that you know what each option is, let’s give a detailed breakdown of each to help you decide which option is best for your current (or future) situation.

 

SAFE (Simple Agreement for Future Equity) – Best for startups in the very early stages that need quick capital without having to determine the valuation of the company.

 

SAFEs were originally created to deal with the challenges startups have faced during their early funding stages when they may not have a clear valuation of their business. Using a SAFE for funding was the perfect solution, as the startup could receive upfront funds from an investor in exchange for future equity in their company.

As the acronym states, SAFE is a “Simple Agreement for Future Equity” that gives the investor future equity in the company in exchange for the upfront funds. SAFEs are quite popular due to their simplicity – they can convert into stock in a future price round, and since they are a “non-debt” investment they do not have maturity dates and the startup is never required to pay the investment back with interest. In addition, since SAFEs postpone any discussion of valuation until later, startups can use the upfront funds to focus on securing capital and growing their company.

SAFEs can usually convert at any dollar amount and have a simple issuing process – you create the agreement between the investor and startup, sign all the required documents, and then receive the funding.

 

PROS:

  1. Simple and fast – SAFEs are simple and fast to complete since they delay the valuation of the company and do not require debt repayment pressures.
  2. Flexible – The delay in valuation offers a flexibility not found in other funding options, giving the startup more time to grow the company without needing to establish a valuation price.
  3. Lower dilution – The startup founder may end up getting a better deal in the long run if the company’s valuation increases significantly after the SAFE investor already pays a maximum price for shares.
  4. Liquidation priority – The investors are also protected if the company dissolves because they will get their investment back before common shareholders.

 

CONS:

  1. Potential startup cost – With high growth comes consequences for the startup, as the SAFE discount rate may not be enough if the subsequent funding round has a much higher valuation. This would result in a higher cost for the startup company.
  2. Limited rights for the investor – Investors in a SAFE agreement have less rights than other standard investors, such as no board representation or voting rights until the conversion.
  3. Dilution potential and investor attraction issues – Although a startup would benefit if their valuation were higher than expected, low valuation caps may lead to significant dilution and may be more difficult to attract investors.
  4. Conversion issues – Conflict and tensions may arise between startup founders and investors when negotiating the conversion valuation, and the SAFE may not convert into equity if there isn’t a future funding round or acquisition.

 

CONVERTIBLE NOTES – Best for startups that need flexible capital in the very early stages without an immediate valuation of the company.

 

Convertible notes (also called convertible debt securities) are short-term loans that convert the equity received after a period of time, usually in a future funding round. Unlike SAFEs, however, convertible notes are a type of debt instrument, which means they accrue interest and have a maturity date. This date could be a future qualifying event or transaction agreed upon by both parties.

If the note does not convert by the maturity date, the startup company would need to repay the noteholder’s initial investment plus interest. That being said, the agreed upon maturity date could be extended if both parties agree (but would also continue to accrue interest during that extended period of time).

Since the startup’s valuation determines how much equity the startup will receive, the investor will usually know the startup’s valuation before a fundraising round. However, this may be difficult (or even impossible) to determine if the startup is too new to calculate an accurate valuation. This problem can be solved by using “convertible equity,” which means the equity will be converted once the company has a firm valuation.

Similar to SAFEs, convertible notes may also have valuation caps and/or conversion discounts, which are attractive to early investors because they can convert their shares to equity at a lower price than later investors. Valuation caps reward early investors by setting a maximum valuation to keep the valuation price down if the startup’s valuation grows quickly, while conversion discounts give early investors a discount on their price per share. These features make it easier to attract investors early than SAFEs because they will get the lowest conversion price per share.  

Convertible notes could be valuable financing options for startups that need capital quickly, yet also want to reach a specific milestone before their pricing round. However, there are also downsides like dilution.  

PROS:

  • Fast, affordable, and flexible – The simplicity of convertible notes makes fundraising quick and affordable, while also flexible by delaying the setting of a startup’s valuation.
  • Investor protection – This is still a debt instrument, which means the investors still collect interest and this offers some protection in case the startup ends up struggling financially.
  • No fixed valuation of the startup – Many startup founders are unsure how their company will grow, so convertible notes give time to develop metrics and measure the company’s value before a future round of funding.
  • Rolling closings – Capital can be raised from different investors over a period of time, not all at once, so startup founders will not need a lead investor to control the round.

 

CONS:

  • Additional costs for startups – With debt instruments come additional costs, like accrued interest, which adds to the cost if converted at a high valuation. There is also the potential for repayment if the conversion does not happen by the maturity date.
  • Potentially greater dilution – Unlike SAFEs, this accrued interest can result in a greater chance for dilution. There is also a potential for anti-dilution protection if investors negotiate features to make conversions cheaper if the startup raises future funds at a lower valuation. If the startup raises too much in convertibles or converts at low valuations in a future price round, this can also dilute the ownership.
  • Less control and more uncertainty – Investors do not have voting rights until the conversion, so there is less control on the investor side. For both investors and startup founders, the valuation of conversation can create uncertainty (on both sides).
  • May still require valuation – If a valuation cap is put on convertible notes, there will eventually need to be some kind of pre-money valuation proxy that is agreed upon by both parties.

 

EQUITY ROUNDS – Best for established startups that can forecast valuations, will benefit from a more formal investment strategy, and don’t mind giving rights and power to investors by essentially sharing ownership.  

 

Equity rounds involve a direct exchange of money for shares at a mutually agreed upon price. This transparency can be beneficial for both the investor and the startup founder in that they know exactly what they are getting (and giving up) immediately.

Equity rounds may be the most beneficial for investors, and the easiest way to entice funding, in that they will typically have more power outlined in a shareholder agreement like voting, board seats, and anti-dilution provisions. So, equity rounds can be powerful motivators for attaining higher amounts of funding from experienced investors, but are also more complex and expensive than SAFEs or convertible notes.

What else makes equity rounds different than SAFEs or convertible notes? The company’s valuation and share price are set and negotiations are involved. Since usually more established startups can foresee an established valuation, equity rounds are beneficial for bigger rounds rather than smaller wones that do not need the time (and money) needed to deal with everything upfront – valuation, attorney and accounting fees, due diligence, etc.

PROS:

  • A clear and transparent structure – Everything is laid out in an ownership agreement, and usually when investors own a piece of a startup, they are also financially tied to the success. This means long-term investments and a potential for larger funding for the startup.
  • Attracting talented investors – Equity can be a valuable tool in attracting both talent and capital, both on the investor side and later on the employee side. Remember the investors not only bring money, but also business expertise and connections.

 

CONS:

  • Loss of control – With the benefits of equity and expertise come a loss of control when startup founders give voting power and decision-making to investors. If negotiations are not agreed upon in the beginning, this could potentially lead to disagreements and conflict down the road.
  • Long-term commitments – Equity notes are supposed to be for the long haul, so you will want to make sure you can be locked into this partnership with investors for a long period of time.
  • Expensive – Since equity notes involved detailed and formal negotiations outlined in agreements reviewed by attorneys and accountants, they are more expensive than SAFEs and conversion notes.

 

The Bottom Line

We hope this provides a detailed comparison of the pros and cons of SAFEs, conversion notes, and equity rounds. By having a clear understanding of each funding vehicle, startup founders can make informed decisions about which option will work best for their company.

Choosing the right funding vehicle usually depends on a variety of factors, from your startup’s stage and fundraising goals to your comfort in giving up control and potential dilution. Over the past year or so, we have found that SAFEs have become more popular than conversion notes and equity rounds since they are a good starting point for early-stage companies because of their simplicity and cost. However, some of our more seasoned clients lean towards convertible notes and equity rounds. On one hand, convertible notes have less documents than equity rounds because you are not giving up control. Yet, equity rounds will entice talented investors with larger dollar amounts.

If you are unsure which fundraising vehicle is right for your startup, feel free to contact us and we can run through each option!

 

 

About Critical Connexion:

Critical Connexion is a distinguished business management & consulting firm that focuses on leveraging a foundation of leading finance, HR management, strategic sourcing, risk & operations experts to accelerate brand success for clients.

We specialize in navigating the evolving landscape of corporate growth by adeptly addressing changing systems, processes, and people requirements. Recognizing the substantial nature of technology and changing business needs, we ensure that these resources are directed with foresight and expertise. We are your extended partners for business growth, scaling seamlessly and brand elevation.

 

Contact Us:

Ph: 213-798-6676
Email: info@criticalconnexion.com