Both SAFE notes and convertible notes are common financial instruments used by early-stage companies to raise capital from investors.
SAFE notes are equity agreements without debt, interest, or maturity dates, while convertible notes are short-term debts that convert to equity, with interest and a set maturity date.
While convertible notes are more traditional, SAFEs are more popular in startup environments thanks to the simplified and streamlined fundraising process they have to offer.
In this article, we will unpack the SAFE vs convertible note debate, explore their key differences and unique features so you can make an informed choice for your fundraising needs.
Let’s dive in!
Key takeaways
- Convertible notes are short-term loans to startups that mature into equity over time. Once a prescribed threshold is met, this triggers an event where the note is converted into preferred stock for the investor.
- SAFE notes are an alternative to convertible notes, designed to make fundraising easier and faster, with the intent of converting to equity during the subsequent round of funding.
- Convertible notes accrue interest and have maturity dates; SAFEs, since they are not a debt instrument, do neither — they only function as a legal agreement to buy shares in the future.
- Using contract creation and management software is a reliable way to write SAFE and convertible notes, helping avoid any misunderstandings between founders seeking capital and investors looking for max ROI.
What is a convertible note?
A convertible note is a type of investment popular among seed-stage startups seeking to secure funding without immediately determining their business valuation — in its place, a valuation cap is set for the benefit of the investors.
Instead of receiving interest rates and fixed repayment like in a traditional loan, convertible notes are issued by investors in exchange for equity in the company.
Simply put, an investor’s money can convert to equity (usually in the form of preferred shares) when certain conditions are met. For example, when a startup raises a certain amount of capital in the next round.
Here is a breakdown of how convertible note works:
Issuance
Investors lend money to the startup in exchange for convertible notes;
Interest
Convertible notes accrue interest like any other debt investment, but it is typically not paid in cash.
Maturity date
There’s a deadline when the notes must convert into equity or be repaid.
Conversion
Convertible notes have flexible conversion triggers.
A trigger is a specific event, often a future financing round that converts notes into shares of the company.
In contrast to SAFE notes, convertible ones start as a debt.
Convertible notes may be more preferable among investors since they are less risky, have a clearer structure with predefined terms, accruing interest and a maturity date.
Example of a convertible note
An angel investor lends $50,000 to a startup using a convertible note. The terms of the note are:
- 20% discount;
- 6% interest per year;
- Automatic note conversion after a funding round of $1 million.
The Share price was originally $2. Thanks to the discount, the investor can now get the startup’s shares at $1.6.
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Use this templateWhat is a SAFE note?
A Simple Agreement for Future Equity (SAFE) note is a financial instrument used in startup financing designed to simplify the fundraising process by deferring valuation discussions and avoiding interest accrual or repayment.
Here is a breakdown of how SAFE note works.
Issuance
Investors provide money to the startup in exchange for SAFE notes.
No interest or maturity date
SAFEs don’t accrue interest or have a deadline for conversion.
Conversion
Conversion happens during a future financing round, generally the next one.
Terms
SAFE notes have predefined terms, such as a valuation cap or discount rate that determines the conversion price when the event occurs.
In contrast to convertible notes, SAFEs are not debt instruments, meaning they do not require interest accrual.
They represent the promise of future equity in the startup, so investors provide capital in exchange for the right to convert SAFEs into equity during a future financing round.
Example of a SAFE note
Suppose our investor puts up $50,000 for a SAFE note. The same 20% discount rate applies and a valuation cap of $2 million is set.
The startup conducts a Series A financing round with a valuation of $5 million and a share price of $5 per share. The investor’s SAFE note would then convert as follows:
- If the discount rate is more favorable: The investor’s $50,000 investment would be converted into equity at a price of $4 per share (20% discount from $5).
- If the valuation cap is more favorable: The investor’s $50,000 investment would be converted into equity at a price based on a $2 million valuation cap.
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Use this templateKey terms for convertible notes vs SAFE notes
Valuation cap
Caps protect investors by creating a maximum valuation at which their invested capital will convert into equity when specific conditions are met.
Let’s consider a $100,000 investment in a startup, and a valuation cap of $1 million.
This would equate to 10% equity once the $1 million valuation is reached.
The equity percentage would stay that way for the investors, even as the company is valued at, say, $5 million at a later date — the investors would still own 10% of the company.
Investors often negotiate to include a valuation cap in a convertible note.
The reason for that is they play a pivotal role in enabling the startup to attain a substantial pre-money valuation during the Series A preferred stock financing — as mentioned above, investors will benefit from the cap, especially in case of significant valuation growth between the time a note is issued and the qualified financing round.
Pro rata rights
These allow investors in SAFEs to buy additional shares if the startup raises a further round or rounds of financing, ensuring that they can keep their ownership level consistent as the company raises more capital.
Discount Rate
Inventors are offered a discount on future stock purchases, a share price that will be less than what others will pay later.
The discount is used as a way to offset the risk that investors take on when funding an early-stage startup.
For example, with a 25% discount rate, note holders can buy the company’s shares sold at $20 for only $15.
Interest Rate
Relates only for convertible notes: The interest accrues over time until the triggering event occurs or until the maturity date, increasing the investor’s share count at conversion.
For example, an investor agrees to provide $100,000 in funding via a convertible note with 5% interest rate per annum in terms. Each year an investor will get an additional 5% of the principal amount — $5,000 added to the note as interest.
Maturity Date
Relates only for convertible notes: Maturity dates represent the date by which the startup either repays the convertible note with any accrued interest or renegotiates its terms.
The startup should start seeking financing when the maturity date approaches.
If the startup considers itself able to recruit investment, founders should start seeking funding at least six months before the date.
If a startup thinks is unlikely to qualify for financing, then founders should consult with their investor(s) and discuss how to proceed.
Deciding between a convertible note and a SAFE note
The main differences between SAFE and convertible notes are their legal structure and how they operate in startup financing:
| SAFE note | Convertible note | |
|---|---|---|
| Contractual obligation | Not a debt, so it doesn’t require the startup to pay back the investment with interest | Acts as a business loan that converts into equity financing instead of being repaid |
| Complexity | Designed to simplify the funding process with less legal work and negotiation | Involve more complex negotiations, require agreement on interest rates, repayment terms, and valuation caps |
| Interest and maturity | Do not accrue interest and have no predetermined maturity date for repayment | Convertible notes accrue interest over time or have a maturity date |
| Valuation cap | Allow startups to defer valuation discussions until a future financing round to get more accurate valuation based on business performance | Begin with a predetermined valuation cap or conversion price, allowing for more certainty upfront |
| Investor protection | Usually have a valuation cap or discount rate | Have a cap, discount rate, accruing interest and a maturity date for more investor’s protection |
| Audience | Typically preferred by early-stage startups that have not yet raised significant funding | Typically preferred by more established startups that have already raised some kind of funding |
Tackle writing convertible notes and SAFE notes easily with PandaDoc
In summary, both convertible notes and SAFE notes offer a way for entrepreneurs to raise capital.
Convertible notes deliver more immediate investor clarity and safeguards, with established valuations, the ability to accrue interest and set maturity dates.
SAFE notes present a simplified and adaptable method — they postpone valuation negotiations while appealing to investors with valuation caps and discounts.
The choice between these two notes will always be based on the startup’s specific circumstances, fundraising goals, and the preferences of potential investors.
Whichever is the best fit for your current needs, PandaDoc’s contract management software can help streamline the process.
Our solutions include ready-to-use SAFE note templates, convertible note templates, and the ability to easily share completed, legally binding docs with electronic signatures.
Sign up today for a two-week free trial or schedule a quick demo to see how the PandaDoc platform can assist you and your team!
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