SAFE and Convertible Note Financing for Early Stage Companies
SAFEs and convertible promissory notes are popular forms of early stage finance for private companies. This article briefly reviews the general differences between the two.
What is a SAFE?
The “Simple Agreement for Future Equity” or SAFE is a streamlined investment instrument that has emerged as a popular alternative to traditional convertible notes. An investor will purchase a SAFE and in return, the company promises that at the next sale of preferred stock the SAFE will convert into preferred equity, usually at a discount or perhaps tethered to a certain valuation of the company. Contemporaneously with purchasing a SAFE, investors can also enter into side letter agreements for additional rights, including the guarantee of pro rata participation at the preferred round, board observer rights, and/or information rights.
SAFEs permit companies to raise investment capital without needing to undertake the complex process of issuing preferred stock, which would also require establishing a market price for the share price of the preferred securities. Governance of the company and investor protections and preferences are typically also negotiated at the sale of preferred securities, and can take oftentimes take weeks to resolve.
In contrast to traditional convertible promissory notes, SAFEs do not carry any maturity date, and interest does not accrue with a SAFE (and the investor is not considered a creditor). In fact, many forms of SAFEs will expressly note that the SAFE will be considered junior to the rights of creditors or other convertible notes. SAFEs can thus remain outstanding for years—until or unless the company ultimately issues preferred stock, or, there is a sale or other liquidation of the company. Because the obligation to pay back a SAFE generally only takes place at a sale or liquidation, it is more company friendly than a convertible promissory note.
Understanding the convertible promissory note
A convertible promissory note is akin to the SAFE in that it provides a relatively simple means of investment in the company with the expectation that the investment amounts will convert into company equity at a later time. However, in contrast to the SAFE, the convertible promissory note is treated as a loan—and the investor is a creditor—until the time of conversion. Convertible notes will carry a maturity date at which time the funds will be due for repayment with interest (both such terms subject to negotiation. Sometimes, convertible promissory notes provide the investor the option to convert upon maturity at some pre-negotiated terms, perhaps into the last series of preferred equity or into the common stock of the company.
Just as with a SAFE, a convertible promissory note will typically provide a discount to the investor upon conversion into equity, or conversion tethered to a pre-negotiated company valuation.
A convertible note is generally considered more investor friendly than a SAFE because the investor will be a creditor and will have legal rights upon maturity if the funds are not paid back.
While SAFEs have been popular in recent years, in tougher investment conditions it is possible that convertibles promissory notes may re-emerge as the go-to instrument for early stage financing, since they are generally more investor friendly.
It is very important that private companies comply with federal and state securities rules in issuing either SAFEs or convertible notes, and there can be serious legal consequences, including possible criminal liability, for the company and its board and/or officers for failure to comply with such rules.
