Raising Capital for Your Startup – The Benefits and Pitfalls of Convertible Promissory Notes and SAFEs

Two ways startups typically raise early capital are by issuing simple agreements for future equity (“SAFEs”) or convertible promissory notes (“Convertible Notes”). SAFEs and Convertible Notes have many characteristics in common, such as the ability to defer the valuation process for an early-stage startup. Understanding the benefits and pitfalls of each is critical for both startups and their investors who wish to use the financing method which best fits their needs.

What Are Convertible Notes and When Should a Company Issue Them?

Convertible Notes are non-equity debt instruments which convert into equity upon the occurrence of some future event. Many companies choose to have their Convertible Notes convert upon the election of the noteholder or automatically convert on the occurrence of a specific future milestone of the business (such as an equity raise of a certain minimum amount).

By lending money to the company rather than investing directly in equity at the outset of a startup, the lender is protecting herself from additional risk. If the startup were to fail, debt holders receive a priority over equity holders with respect to any cash or assets that the company may own upon dissolution. In return, during the debt phase of the Convertible Note, the note holder will not be able participate in any appreciation of value of the equity of the company. To the contrary, as the equity appreciates, the note holder will receive less and less equity upon conversion.

Generally, in a Convertible Note offering, the terms and provisions of Convertible Notes often are set out in a term sheet which is used to promote and invite the investment. Once investors are committed to the Convertible Note purchase, the investor and the company must execute a convertible promissory note and often a note purchase agreement. The note purchase agreement is the contract which outlines the terms of the purchase as well as includes securities law representations and restrictions.

It is important to keep in mind that a Convertible Note is still a security according to both federal and state law. This means that an exemption to the registration requirements must be found and proper paperwork and notices must be filed with appropriate authorities for the Convertible Note offering.

The following are some of the key terms which are generally included in a Convertible Note.

Interest Rate and Maturity Date

Just like any other type of debt, Convertible Notes normally include an interest rate, typically ranging from 4% to 10% per annum, and a maturity date upon which the outstanding principal amount and accrued but unpaid interest is due to be repaid to the investor. In one version of a Convertible Note, a company may have the opportunity to make interest or principal payments to reduce the amount owed at the maturity date. In another scenario, a company may be forced to repay the entire principle amount on the maturity date if the lender elects not to convert. Having said that, investors who invest in a company in exchange for Convertible Notes rarely expect a simple return on the principal. Rather, they take on the high risk of investing in an early-stage company for a potential vastly larger return on future equity. As a result, investors almost always convert the Convertible Notes into equity on the maturity date.

The term for a Convertible Note is generally 18 to 24 months, but may vary depending on the specific needs of the company. As interest accrues during the term of the Convertible Note, it will be important for the company to consider how interest will be calculated. Whether interest is compounded monthly, annually or as simple interest, and over what length of term, will greatly affect the final dollar amount which is to convert into equity. A company which does not fully consider the equity given upon conversion may end up giving away control of the company.

Events that Trigger a Conversion to Equity

The event which will typically prompt the automatic conversion of Convertible Notes to equity is the company’s next equity financing round (a “Financing Event”). An investor is interested in converting debt into equity in the event of a Financing Event because the investor wishes to participate in the growth of the company, and the risk of the company failing has been reduced once another party invests a larger sum of money. The company already has deferred the question of valuation until the Financing Event and will give significantly less equity to the note holder than if it had sold equity to the note holder at the outset. By having the Convertible Note convert into the same equity which is being sold in the Financing Event, the company will reduce legal fees, paperwork and negotiation time that would have occurred if a separate offering for equity were conducted.

Alternatively, the note holder may have an option to convert upon the maturity date if the Convertible Note was not paid in full or prior to a Change in Control of the company. The term “Change in Control” commonly means the merger, sale or conveyance of all or substantially all of the assets of a company. Optional conversions are important because they give the investor alternatives to collecting on the debt in the event that the company cannot or does not need to conduct a Financing Event.

Conversion Price Discounts vs. Valuation Caps

In order to encourage investors to purchase Convertible Notes rather than waiting for a Financing Event, a company may offer a discount to the conversion price at the time of conversion. The conversion price is typically discounted by 10% to 25%. If, for instance, on the date of conversion the conversion price was $1 per share and the discount was 15%, instead of purchasing the equity at $1 per share, the investor would be able to purchase the equity at $0.85 per share.

As an additional assurance given to investors, the company sometimes adds a valuation cap to the conversion price. A valuation cap is a provision which sets a maximum valuation of a company for the purposes of setting the conversion price. This ceiling assures investors that no matter how well the company does, the price per share the investor will receive will never go above a certain number. This allows investors to determine the minimum number of equity they will hold upon conversion. Companies should explicitly provide that the valuation cap is based on either pre- or post-valuation money to prevent disputes as to which valuation applies upon conversion.

Advantages of Convertible Notes

Unlike traditional loans, Convertible Notes benefit the company by allowing the company to borrow cash without the burden of paying off the loan in cash.
Convertible Notes allow the company to defer setting a valuation on the company until a later date at which the company is more valuable (usually after there are some revenues).
As debt, Convertible Notes have a higher priority than equity in the event of the dissolution of a company. Thus, investors have a lower risk before conversion.
Convertible Notes provide the investor with a significant discount on their conversion price upon conversion of the Convertible Notes to equity.

What Are SAFEs and When Should a Company Issue Them?

Initially established in 2013 by Y Combinator, SAFEs are non-equity contracts, in which the investors agree to receive equity from the company at a future date while paying money in the present. Under a SAFE, a startup will issue equity only upon the occurrence of a triggering event – just like in a Convertible Note – which is often the next equity financing. Both Convertible Notes and SAFE have similar terms (conversion discounts and valuation caps upon a conversion to equity), except SAFEs purchase the equity in contract while Convertible Notes are debt.

A SAFE is generally more favorable to the company as there is not a debt instrument that must be repaid to the lender, and there are no interest payments or maturity date. If the company fails, SAFE holders at best may recover only on the same terms as the other equity holders. Although SAFEs are simpler than Convertible Notes due to the simplicity of the transaction, they are also higher in risk. Generally, SAFEs are used by large venture funds and high net worth individuals who are not afraid of the loss as recovery may not be possible.

Despite their contractual nature, SAFEs are securities under state and federal securities laws. This means that an exemption to the registration requirements must be identified, and proper paperwork and notices must be filed with appropriate authorities for any SAFE offering.

Advantages of SAFEs

Unlike Convertible Notes, SAFEs do not have a debt aspect and, thus, do not include terms such as interest rates or maturity dates. There is no requirement to pay back any principal or accrued interest to the investor. SAFEs will convert automatically into equity in the next round of equity financing. One of the consequences of having a maturity date is that it sets a target deadline for startups to seek the next capital financing. SAFEs do not set that pressure on startups, allowing issuers to focus on the business and take the time to seek suitable equity financing from investors who are aligned with both the short-term and long-term goals of the startup. Both Convertible Notes and SAFEs are useful tools for startups, though one may be better than the other depending on the facts at hand and the preferences of the parties.

Please contact the author at durdana@encorelaw.com.

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