Fundraising for Your Company: Convertible Notes, SAFEs, and Priced Rounds
New startups often raise capital through convertible instruments such as SAFEs or convertible notes. Convertible instruments allow founders to raise money without lengthy negotiations on your company’s valuation, equity ownership protections, and voting and management rights.
Convertible Note
A Convertible note is a type of debt that can convert into equity upon a triggering event, such as an equity round greater than $5 million. As debt, convertible notes include both an interest rate (2–8%) and a maturity date at which point the note ends. Interest accrues until the debt is repaid or the investor’s money converts into equity.
At the maturity date, the company must pay back the investor’s principal investment and the interest accrued over time. The parties can mutually amend the note to extend the maturity date, if needed. The maturity can even be structured to have the notes become due only at the demand of the noteholders, who are often friendly investors that may defer collecting on the note. The interest makes convertible notes more expensive to startups than a non-interest bearing SAFE.
Convertible notes often include terms favorable to early investors who take a larger risk to invest in the business. For example, convertible notes may include a valuation cap or a conversion discount, which reward early investors with a lower price per share on conversion into equity. A valuation cap sets the maximum price per share at which the note converts into equity. On the other hand, a conversion discount provides investors a discount on the price per share when their note converts into equity.
SAFEs
SAFEs convert into equity upon a future investing round, often at any pricing, unlike convertible notes which stipulate a certain amount of capital to be raised. SAFEs are a type of warrant not debt, so they do not include an interest rate or maturity date but do often include a valuation cap or conversion discount. However, SAFEs do have a latest date for the note to convert into stock or be repaid. SAFE stands for “Simple Agreement for Future Equity.”
Priced Rounds
In contrast to convertible instruments, priced rounds require a negotiated valuation of the company. Investors then invest money in exchange for preferred or common stock in your company at the price per share set by the valuation.
Preferred stock often includes preferential features such a liquidation preference or preferential distribution of profits. Furthermore, preferred stock may include voting or management rights in your company. Because of these investor-friendly terms, priced rounds are often more appealing to investors.
Other Considerations
SAFEs are often part of a series of SAFEs purchased by investors at different times, while convertible notes are often part of a single Note Purchase Agreement that details the financing terms. Also note that investors are often more tolerant of convertible notes than SAFEs.
SAFEs are comparatively standardized across the industry, and tend to include certain investor-friendly terms, such as pro rata participation rights to allow an investor to retain their ownership percentage in future equity financings. Convertible notes are less standardized, so provide more flexibility but require additional negotiation on terms.
Priced rounds often require more time for the additional accounting and negotiation, which translates to higher legal fees. The preferential rights granted to investors often results in loss of control over your company.
LawChamps can connect you with a knowledgeable attorney to discuss the best option for you to finance your startup.
This article is intended to convey generally useful information only and does not constitute legal advice. Any opinions expressed are solely those of the author, not LawChamps.
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