Safes notes vs Convertible Notes: Everything You Need to Know

Safes notes vs Convertible Notes: Everything You Need to Know

To determine whether SAFE Notes or Convertible Notes are better for your startup, you need to understand the difference between the two. ‌

Would you like to use equity finance? 

Startups are usually not very valuable. Once the company is established, the founder can acquire the shares at the minimum amount specified in the company's articles of incorporation. It can look suspicious to the IRS if they reverse the preferred stock and sell it at a much higher price. 

A startup lawyer created the convertible bond to avoid this problem. This allows startups to receive seed capital later without going through the evaluation process. Convertible bonds are debt securities that allow a company to raise the necessary funds in a short period of time without having to sell its shares due to a significant surge. 

However, convertible bonds can be confusing and complex. In 2013, Y Combinator created SAFE Notes to facilitate the process. SAFE notes are not debt. They are convertible bonds. There are no loans or due dates. 

Benefits of the SAFE notebook 

Convertible bonds are long documents that contain many variables. Understanding the terms can mean a lot of interaction between investors, founders, and their lawyers. SAFE Notes is designed to simplify and standardize the process of procuring seed capital. ‌

What is the difference between SAFE Note and convertible bond conversion?

Both SAFE notes and convertible bonds need to be converted to equity. The main difference is that the SAFE note specifies a specific conversion method, while the convertible offers different conversion conditions. SAFE notes will be converted to preferred stock in the next round and issued in the next round of priced funding, converted if the price round results in any amount of equity financing. 

When a qualified transaction occurs, a startup raises the minimum amount ‌when an investor and a company agree to a conversion.

Rating limit and dilution 

Both SAFE notes and convertible bonds need to negotiate a valuation cap. It's important to understand how rating caps affect your business. Securing funding inequity reduces your share of ownership. The valuation limit is the maximum valuation used to calculate the stock price at which an investor's money is converted into stock. 

For example, suppose you receive a significantly higher rating than your grade limit in your next round of equity finance. If so, you may be issuing far more shares than you expected. ‌

Some particularly strong startups may be able to negotiate unlimited SAFE or convertible bonds, but valuation caps are one of the most attractive aspects of either type of bond. Before negotiating a cap, it is important to consider how much ownership can be diluted in subsequent eligible funding rounds. 

Interest Rate 

SAFE bonds are not loans, so only convertibles process interest. Interest rates on convertible bonds typically range from 2 to 8 percent. Like capital, interest on convertible bonds is converted to equity when a trigger event occurs. SAFE bonds are not liabilities and therefore have no interest or maturity. That is, the level of ownership of an investor does not change based on the holding period of the bond. 

Early Termination 

Both SAFE bonds and convertible bonds contain provisions related to payments if a company experiences a change of control, such as a buyout or IPO, prior to conversion. With SAFE Note, investors have the option to convert to equity with a valuation limit or a 1x payment. However, SAFE can handle these changes in terms and conditions in a side letter.

Convertible Bond Maturity Date 

This is just a convertible bond issue, as SAFE notes have no deadline. Convertible bonds usually have a maturity date of 18 to 24 months after closing. Ideally, the next round of funding will take place before the due date. 

Suppose the next round does not come before the due date. In this case, the startup must repay the loan's principal and interest in full, convert the debt to equity, or apply for an extension on the due date. ‌

Loan repayments are usually out of the question because most startups are bankrupt. The bankruptcy of convertible bonds can lead to bankruptcy. This is one of the clear advantages over convertibles as SAFE is not a loan and does not require repayment.

Structural Difference 

SAFE Notes gives you greater funding flexibility. As a rule, these are independent contracts issued to individual investors. SAFE Notes allows startups to reward former investors with cheaper valuation caps. If investor interest grows, it can be issued on a rolling basis under different conditions. They provide companies with the opportunity to test the market and adjust conditions continuously. ‌

 It isn't easy to track some cap tablet tracking conditions as these are loans with due dates and interest rates to consider. Convertible bonds usually consist of a single legal agreement covering all convertible bond loans. This is called the Note Purchasing Agreement (NPA) and contains all the conditions.

Convertible Bond Conditions 

 The details of the convertible bond agreement are different, but all include the following terms:  

Valuation limit: Maximum valuation when bonds are converted 

Discount rate: Discounts received by investors compared to future investors‌ 

Loan interest rate: Amount to be repaid as equity 

 Due date, the date that must be repaid if the loan has not been converted 

SAFE Note terms 

 SAFE bonds have several options, including: 

 -Valuation cap but no discount 

 -Discount but no valuation discount 

 -Valuation cap and discount  

 Most Favorable Country (MFN) status, that is, early bondholders, are included in later SAFE provisions. 

Proportional Allocation Rights 

SAFE Bonds typically include a valuation cap and discounts that allow investors to invest additional funds to retain a share of ownership in future equity lending. Investing in startups is a risky venture, so most investors want high returns. 

Investor Comfort 

Convertible bonds are familiar to most investors. Silicon Valley investors may be familiar with them, as Silicon Valley's renowned technology accelerator created SAFE Notes. Investors also like convertibles because they are more restrictive to their founders, have maturities that require renegotiation to renew and bind collateral and assets. 

On the other hand, the SAFE Note is not a debt certificate, giving the founder more flexibility. In addition, they are freely available and easy to understand, so lawyers no longer need to negotiate. For these reasons, they are considered more founder-friendly. ‌

 If investors are willing to invest in comfortable and safe notes, they are probably familiar with convertibles. Investors accustomed to convertible bonds may be unfamiliar with or unwilling to consider SAFE bonds. 

Final Thoughts on the SAFE Note and Convertible Bonds 

There is no clear answer as to which of the SAFE Note and Convertible Bonds are best for your business. What you choose depends on your particular business situation. While convertibles give startups the obvious advantage of delaying valuation and focusing on starting a business, SAFE bonds may still require an A409a rating.

SAFE Notes has several important advantages, including fewer bargaining points and better control over your company. But if they can't attract the investors you want, you may have to go convertible. ‌

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