Startup Seed Financing Instruments: Convertible Notes and SAFEs
After formation, when a startup company is ready to raise its initial seed capital (in what is known as a seed round or seed financing), the company and its prospective investors must first determine how to structure the investment. The most common financing instrument that startup companies use for seed investment is a particular form of debt security: the convertible note.
This Note explains the main features of convertible notes and the simple agreement for future equity (SAFE) used in seed financings. This Note assumes that the company raising capital is a startup organized as a Delaware C-corporation. This Note also assumes that all of the instruments discussed are issued in private placements to accredited investors, and not in offerings registered with the SEC.
Convertible Notes
The most frequently used instrument for raising modest amounts of capital at the seed stage is the convertible note. This Section describes:
- The hallmark debt features of convertible notes
- The mechanics by which the notes convert to equity
Convertible note instruments in the startup context typically provide their holders with relatively few rights and protections, particularly compared to those usually afforded preferred stockholders. Convertible noteholders generally only receive:
- A creditor’s claim to its principal and interest.
- The right to receive equity of the company under certain specified circumstances.
More developed startups also use convertible notes as bridge financing to a later-stage equity round or a sale of the company. For this reason, convertible notes are sometimes referred to as bridge notes.
Debt Features
Convertible notes contain the following key terms that define debt instruments:
- A principal balance
- An annual rate of interest
- A repayment or maturity date
- A priority ahead of the company’s equityholders in a liquidation
Although convertible notes are technically debt instruments, many investors view the instrument as deferred or unpriced equity in substance. They are also deemed to be securities by the SEC, and thus the company has to follow the regulations for issuing securities. The goal of their investment in the notes is to convert them into the same preferred equity security sold to the first institutional venture capital (VC) investor in the company’s Series A round, rather than to receive their principal plus interest at maturity. Investors therefore typically view the conversion features as the most important provisions in a convertible note deal, as those are the mechanisms by which the noteholders eventually become stockholders of the company.
Principal
The principal amount of a convertible note represents the actual amount invested by the noteholder in the note. The aggregate principal amount of notes sold in a typical convertible note financing can range from tens of thousands of dollars to upwards of $1 million.
Interest
Convertible notes have an annual interest rate, which have typically ranged from 2% to 12%, with between 4% and 8% being the most common. Unlike a bond’s coupon payment, this interest accrues and is either:
- Added to the principal balance when a note converts into equity.
- Paid to the noteholder in cash at the time of conversion or repayment.
While some less savvy startup investors may try to negotiate the interest rate, more experienced angel investors largely ignore the interest rate and focus on the key conversion price terms: the discount and valuation cap. More sophisticated investors usually know that the conversion price tends to have a much greater impact on their eventual return than the rather modest rate of interest on this short-term instrument.
Maturity
Most convertible notes mature between one and two years after the company issues them. At maturity, each note becomes due and payable on demand by the noteholder. Frequently, there is a no-prepayment clause. This clause, which prohibits the company from prepaying the debt before the maturity date, is often required by the investor since prepaying the note could prevent the investor from converting the debt into shares of the company.
Alternatively, the notes can provide that an entire series of notes become payable on demand by the majority-in-interest of the noteholders in that series on or after maturity. Companies usually prefer this, as it leaves the decision to demand repayment with the largest noteholders instead of allowing each individual noteholder to decide whether it wants its investment returned at maturity.
The company’s failure to repay the notes at maturity is typically not an event of default unless payment is demanded by the requisite noteholders. In practice, convertible notes of startup companies are often left outstanding well past their original maturity date if they have not otherwise converted to equity.
Priority and Security
Convertible notes issued in seed financings are almost always general unsecured obligations of the company. This means the noteholders have a claim on the company’s assets that is senior to all equityholders and typically pari passu with all other unsecured non-senior debtholders. These notes are usually unsecured because the cost of documenting and perfecting a security interest for a seed-stage startup company with little to no assets is rarely worthwhile from an investor’s perspective.
Conversion Events
Convertible notes may convert into different types of equity on the occurrence of any of the following events:
- The closing of a subsequent equity financing of at least a certain minimum size
- The closing of a sale of the company or substantially all of its assets
- Reaching the maturity date of the notes before closing a subsequent equity financing or sale of the company
Next Equity Financing Conversion
A preferred stock financing is the most common conversion trigger (though an issuance of common stock may also cause the notes to convert). This type of conversion event is often referred to as a Next Equity Financing or a qualified financing. In this scenario, the principal and interest of each note converts into the same shares of stock that a new equity investor purchases in the subsequent financing round; however, the noteholders get the benefit of the applicable note conversion price.
To ensure that the equity offering is a bona fide institutional round of financing, investors typically require that the company’s Next Equity Financing raise new proceeds above a certain dollar threshold (often $1 million) to automatically trigger the conversion of the notes. Sometimes, however, that $1 million threshold is drafted to include the aggregate principal amount from the note financing, which may make the threshold less meaningful for the investors (particularly, if the company raises over $500,000 in convertible debt, as is often the case). In some circumstances, the note may contain a provision for optional conversion (at the option of the noteholder) if there is an equity financing that does not meet the level to qualify as a Next Equity Financing.
Corporate Transaction Conversion
If the company is sold while the notes are still outstanding, investors may elect to either:
- Receive the principal and accrued interest (or sometimes the interest plus some multiple of the principal) of their notes.
- Convert the value of their notes into shares of common stock at a discount to the price at which the acquirer has offered to purchase the company’s common stock in connection with the sale transaction. The notes may alternatively convert at the price implied by the valuation cap.
Some convertible note documents also provide for conversion in the event of an IPO. This term is not common due to the unlikelihood of a seed-stage company going public before completing another round of private financing.
Maturity Conversion
If the company reaches the maturity date without having triggered a Next Equity Financing conversion or a Corporate Transaction conversion, noteholders typically have the option to:
- Convert their notes into shares of common stock at a price based on a predetermined formula, often at the price implied by the notes’ valuation cap.
- Demand repayment (although the company would not usually be able to comply, having likely spent most of the note proceeds on building the business).
- Leave the notes outstanding.
Investors rarely choose to convert their notes to common stock. Continuing to hold debt of the company (which has priority in a liquidation), while leaving open the possibility of receiving preferred stock (which has additional rights, preferences, and privileges) in a post-maturity Next Equity Financing, is generally seen as the more attractive option compared to holding common stock alongside the founders.
One exception (albeit a rare one in the startup world) is when a company generates significant profit to reinvest in the business and does not plan to raise additional capital. Investors in this type of company may wish to convert their notes into common stock to receive dividends.
Conversion Price
When a conversion event occurs (most often, a Next Equity Financing conversion triggered by a Series A round), convertible noteholders receive equity based on the principal and interest balance of their promissory notes, but at a price that is lower than the price paid by the new equity investors. The price the noteholders pay is calculated based on one of the following:
- A discount rate
- A valuation cap
Typically, the conversion price is the lower of the two.
Discount
When notes convert at the Next Equity Financing, the price per share used to calculate the note conversion is less than the price per share of the preferred stock the company issues to the new equity investors. The rationale for giving the noteholders the benefit of this discounted price is that the startup has usually “de-risked” to some extent since the noteholders invested. Therefore, the noteholders typically expect to be compensated for having shouldered more risk than the new equity investors (who are investing later).
Discounts in seed financings typically range between 10 to 30% off of the preferred equity price, with the most common discount being 20%. Sometimes discounts are structured to step up based on how long the notes have been outstanding. This type of step-up discount may provide for the following on a note with a two-year maturity:
- A 10% discount if the Next Equity Financing occurs within the first six months of the term.
- A 20% discount if the Next Equity Financing occurs during the following six months of the term.
- A 30% discount if the Next Equity Financing has not occurred within the first year of the term.
Instead of giving noteholders a straight percentage discount on the preferred equity price in the Next Equity Financing, it is possible (and was once common practice) to provide similar economics by issuing the noteholders warrants to purchase additional preferred shares. This practice has largely fallen out of favor due to certain adverse tax consequences of structuring the discount using warrants (stemming mainly from original issue discount issues), but warrants are still sometimes issued in conjunction with convertible notes.
Valuation Cap
Most convertible notes also contain a ceiling, or cap, on the pre-money valuation at which the notes may convert in a Next Equity Financing. The rationale for including a valuation cap is to prevent “valuation whiplash,” in a scenario where a company uses the proceeds of a small convertible note seed round to build a business that supports an outsized Series A pre-money valuation (perhaps upwards of $50 million) in its Next Equity Financing. This outcome would leave the very noteholders whose investment made that valuation possible with a much smaller ownership stake than if they had chosen to structure their investment as equity (priced at a more typical seed-round equity valuation of, say, $5 million) at the outset, instead of as convertible debt. The valuation cap ensures that noteholders still have a meaningful stake in the company if a startup achieves an unusually high valuation in its next financing round.
When notes contain a discount and a valuation cap, the notes convert at the lesser of the price:
- Calculated based on the discount
- Implied by the valuation cap
Valuation caps may range between $3 to 5 million on the lower end and $8 to 10 million on the higher end for a seed-stage convertible note financing, although this can vary significantly in different geographical markets and depending on investor leverage. When valuation caps are on the lower end of the spectrum, counsel should consider advising companies about the impact of phantom liquidation preference.
SAFEs
The SAFE is an alternative to issuing convertible notes when a company is reluctant to issue debt for fear of reaching the maturity date before having concluded a Next Equity Financing. When a startup that has issued convertible debt reaches the maturity date, the founders generally negotiate an extension with the noteholders, who may try to extract better terms in exchange for their consent. The SAFE instrument was created to avoid this renegotiation (and the legal fees it may generate).
Y Combinator coined the term SAFE when it released its form SAFE documents in 2013, which were then updated and re-released in 2018. However, others in the startup finance ecosystem have also created form documents very similar to the SAFE but under different names. This Note adopts the Y Combinator nomenclature SAFE when referring to this type of instrument, as it has developed the most traction in the marketplace to date. Nevertheless, the substance is largely the same regardless of which form a company uses.
Similarities Between SAFEs and Convertible Notes
The SAFE includes many of the most important features of convertible notes, such as:
- Conversion events
- Conversion prices
- Priority in a liquidation
Conversion Events
The SAFE instrument typically includes two of the three conversion events that are found in most convertible notes:
- The Next Equity Financing conversion
- The Corporate Transaction conversion
Conversion Price
SAFEs may include one or both of the following features related to the price at which the instrument converts into equity:
- A discount to the stock price at conversion (
- A valuation cap
Priority
SAFEs typically provide that, upon a dissolution or winding-up of the company (which is not in connection with a sale of the company), the SAFE holders are entitled to receive the purchase price of their SAFEs before the equityholders receive any distribution of the company’s residual assets.
Differences Between SAFEs and Convertible Notes
SAFEs lack the hallmark debt features that are found in convertible notes, namely:
- A maturity date.
- Accruing interest.
Maturity Date
SAFEs do not have a maturity date or any requirement that the amount invested be returned to the SAFE holders at any point in the future (absent a sale or liquidation of the company). Until a conversion event occurs, the SAFE remains outstanding indefinitely. As a result, the SAFE lacks the maturity conversion feature that is commonly included in convertible notes.
Accruing Interest
SAFEs do not include accruing interest on the principal amount invested. SAFE investors typically only receive the right to convert the SAFE into equity at a lower price than the investors in the subsequent financing pay for their shares (based either on the discount or valuation cap in the SAFE).
Drawbacks to Investing in SAFEs
There are several potential drawbacks that counsel should highlight for investors before they agree to purchase a SAFE instead of a convertible note in a seed round. These drawbacks stem mostly from the following two issues:
- SAFEs have no maturity date
- The proper tax treatment of SAFEs is uncertain
No Maturity
The maturity date of convertible debt forces the founders of a company that has not raised a Next Equity Financing by that date to reengage with its noteholders. Since, at maturity, the startup has already most likely spent all of the proceeds from the convertible note offering, the noteholders could theoretically bankrupt the company if they demanded repayment at that time (though this is a highly unlikely outcome in practice). This threat of bankruptcy gives the noteholders some leverage to renegotiate the terms of their investment in the company if it is struggling to find additional investment. For instance, they might require an amendment to increase the discount or lower the valuation cap in exchange for an extension. The lack of a maturity date therefore makes the SAFE a more company-friendly instrument than convertible notes.
There is another situation in which the SAFE’s lack of a maturity date can become a problem for investors. Assume a company takes the proceeds of a seed round in which the investors purchased SAFEs and uses it to develop a business model that generates consistently sufficient profits to reinvest in the growth of the business. This type of company may be able to continue to grow organically without needing to raise additional equity capital. It may be possible, then, that the company never triggers a Next Equity Financing conversion, leaving the SAFEs outstanding and the SAFE holders in limbo until the company is eventually sold or liquidated.
In this scenario, if the company generates enough profit, at some point it may choose to distribute some of those earnings to its shareholders via dividends. Many SAFE documents (including Y Combinator’s original SAFE documents) do not provide a mechanism for the SAFE holders to share in these distributions. However, Y Combinator included such a provision in the second version of its SAFE documents.
If the SAFE holders had invested in convertible notes instead of SAFEs, they would have been able to take advantage of the notes’ maturity conversion feature to become common stockholders and receive these dividends. However, as very few investors in technology startups expect this outcome, many of these investors have been willing to invest in SAFEs (particularly in more competitive deals) despite this risk.
Tax Treatment
Historically, the tax treatment of SAFEs has been uncertain. The SAFE lacks an interest rate and a maturity date, key characteristics of instruments treated as debt for tax purposes. However, it also lacks the terms of a typical equity instrument. Instead, it is a contractual right to buy a company’s stock in the future upon the satisfaction of certain conditions. There is a chance that the SAFE may be treated as a derivative instrument for tax purposes, similar to a prepaid forward contract.
In September 2018, Y Combinator released new SAFE forms, which modified the traditional SAFE forms in a number of ways. The modified SAFE forms (based on a post-money valuation cap) contain more equity-like features than do the original SAFE forms (based on a pre-money valuation cap). From a tax perspective, this feature increases support for “equity” tax treatment from the date of grant. The taxing authorities are more likely to view pre-money SAFEs as variable prepaid forward contracts (which results in pre-money SAFEs being treated as open transactions for tax purposes). Among other things, post-money SAFEs provide holders with rights to receive both the same consideration as shareholders in a liquidity event and the right to receive dividends. The new form also contains explicit language addressing the treatment of such post-money SAFEs as common stock for tax purposes. Because of the differing forms of SAFE (e.g., pre-money versus post-money, including negotiated terms), all parties in the seed round should review the intended SAFE investment with their tax advisors to understand up front the treatment of their SAFE for tax purposes.
