By Doug Bend, founder of Bend Law Group, PC, a law firm focused on small businesses and startups.
Startups raising their first round of capital have to decide which type of investment vehicle to use.
The two most popular options are convertible promissory notes and SAFEs, or simple agreements for future equity.
Convertible promissory notes and SAFEs are similar in that the startup gets investment capital now in exchange for the investor having an opportunity for their investment to convert into equity if there is a triggering event—such as a Series A round—down the road. A key difference is, unlike convertible promissory notes, SAFEs do not have an interest rate nor do they have a maturity date.
Convertible promissory notes used to be more popular, but the increasing trend is that most startups are instead using SAFEs—for four reasons.
1. No Interest Rate
Unlike convertible promissory notes, SAFEs do not include an interest rate.
As such, startup founders have to give up less equity in their company by using SAFEs instead of convertible promissory notes with comparable valuation terms.
2. No Maturity Date
Also unlike convertible promissory notes, SAFEs do not have a maturity date.
The maturity date for convertible promissory notes is often 18 or 24 months. Startups that instead use SAFEs do not have a looming maturity date deadline.
If a startup uses a convertible promissory note and the note has not been converted by the maturity date, the investors have the leverage to negotiate better terms in exchange for extending the maturity date.
3. Speed And Simplicity
SAFE stands for simple agreement for future equity, which can lead to faster investment rounds that not only often cost less money in legal fees but also are less likely to burn through the relationship capital the founders have with the investors.
For example, founders can send investors a redline showing what changes have been made to the SAFE templates that have been open-sourced by Y Combinator. Experienced investors often review those redlines, nod their heads and only focus on the valuation cap that is in the SAFE as they know the other terms in the SAFE are market and fair.
This helps to facilitate quick rounds of raising capital, which not only eats up less of the founders’ time but also decreases the risk that an investor might lose interest in the investment. This feature is particularly valuable now when the investment landscape is quickly changing.
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4. Not A Debt Instrument
Unlike a convertible promissory note, a SAFE is not a debt obligation. This might make it easier for a startup to get traditional financing from banks because there is less debt on the books with a SAFE compared to a convertible promissory note.
Of course, the reasons why founders prefer SAFEs are the same reasons why investors often prefer convertible promissory notes. Investors would prefer for their investment to earn interest and to have the opportunity to renegotiate the terms of the investment if the triggering event has not occurred by the maturity date. In addition, the investors might be more familiar and comfortable with convertible promissory notes as they have been in the startup ecosystem longer than SAFEs.
Long lawyer-story short, if you are a startup founder, you most likely would be best served using SAFEs. Whereas if you are an investor, you most likely would prefer a convertible promissory note.
Either way, founders need to be careful and collaborate with their attorney and CPA to help make sure that the terms and the amount of capital being raised will not overly dilute their ownership allocation in their company.
The information provided here is not legal advice and does not purport to be a substitute for the advice of counsel on any specific matter. For legal advice, you should consult with an attorney concerning your specific situation.
Source by www.forbes.com