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Convertible notes, SAFEs, and priced equity rounds: what's the difference?Convertible notes, SAFEs, and priced equity rounds: what's the difference?Convertible notes, SAFEs, and priced equity rounds: what's the difference?

Convertible notes, SAFEs, and priced equity rounds: what's the difference?

What's the difference between convertible notes, SAFEs and priced equity rounds? Learn the essentials and be prepared to get funding for your startup

So you’re looking to get some funding for your startup? Be prepared to see a lot of fancy words getting thrown at you: convertible notes, SAFEs (Simple Agreement for Future Equity), and priced equity rounds are just a few of them.

You’d almost need a Ph.D. just to understand how these agreements between founders and investors are made. Fortunately, here you can understand the essentials about SAFEs and priced equity rounds, and learn how convertible notes work.

These basics will be enough to get you through the first talks with angels and venture capital funds. Later, they'll also be very useful to get legal advice and understand all the small letters that will appear when you're actually close to sealing the fundraising deal.

Don't want to look like a complete numpty in these situations? Well, you’ve come to the right place. Let's have a showdown between SAFEs, convertible notes, and priced equity rounds.

WTF are SAFEs, convertible notes, and priced equity rounds?

SAFEs, convertible notes, and priced equity rounds all exchange money for ownership, in a way. Even so, there are some crucial differences between these investment vehicles. Let’s have a look.

What are priced equity rounds?

A priced equity round is a direct exchange of money for preferred shares at an agreed-upon price. Investors and founders know exactly what they’re getting and giving up.

In bigger rounds, they’re always the chosen investment vehicle. Smaller rounds don’t merit the amount of time and money needed to deal with the upfront accounting and administration, such as attorney fees and due diligence. And that’s why convertible notes and SAFEs were thrown into the mix, paying clarity as the price.

What are convertible notes?

A convertible note is not equity but a debt that can convert into equity at a later time. This means there is a maturity date at which, if the money doesn't translate into a share in your startup, it needs to be refunded. And you'll need to pay an interest rate to the investors. 

But investors don’t actually care about these small percentage wins. They want to multiply their investment. So why do investors and founders even use convertible notes? There are a couple of benefits:

  • It requires less admin on the legal side than a priced equity round. That means it’s cheaper, faster, and less investor-headache inducing.
  • There’s no need to agree on a valuation right now. What exactly your startup is worth will be decided during the next equity round. More time to make it more valuable!

But there's always some small letters. In some cases, investors will want to agree on a valuation or on a price per share. They want to limit their risk, and they have two tools to do so. Term sheets for a convertible note can have none, one, or both of the next clauses:

  • Valuation caps. Founders and investors agree on a maximum valuation at which the investor’s money will convert into shares, even if newer investors pay a higher price per share.
  • Discounts. Investors get a deduction on the price per share agreed upon with new investors. 

What are SAFEs?

A SAFE, or Simple Agreement for Future Equity, is a legally binding agreement between investors and a startup that gives the investors the right to receive equity in the future. It looks a lot like a convertible note, but it isn’t debt. It combines the benefits of priced equity rounds and of convertible notes. 

The big issues with convertible notes — maturity dates and interest rates — don’t exist with SAFEs. The rest is pretty comparable. Just like convertible notes, it also takes less time, effort, and money to agree on terms. A valuation isn’t always necessary as well.

A short trip down startup investing memory lane

A long time ago, in the early days of startup investing, the most common investment vehicle was a priced equity round

Unfortunately, raising money that way was a cumbersome process, especially for smaller funding rounds, as we've explained. Founders and investors didn’t like all that, as you might imagine. So they found a solution in convertible notes

Convertible notes required fewer documents than the priced equity rounds. However, these convertible notes had problems of their own. They weren’t really aligned with the investor’s goals because the returns on debt are far lower than those on an equity investment.

Nothing seemed to work just perfectly. Then, about 10 years ago, Y Combinator devised a solution. In 2013, SAFEs (Simple Agreement for Future Equity) arrived on the market.

More specifically, YC's SAFEs were pre-money SAFEs. This means a startup’s valuation is determined before the investment money is added. Pre-money SAFEs quickly replaced convertible notes because they don’t require maturity dates and interest rates.

Pre-SAFEs were the norm until very recently. But investors needed more clarity with pre-SAFEs, since they had to wait until the next financing round to figure out the exact percentage of the company they own.

In 2018, YC introduced the post-money SAFE. Since then, this has been the most common investment vehicle for early-stage funding rounds. In this case, the investment money is already included in the valuation. Because of this, investors know exactly how much equity they’ll get once the SAFE converts.

Priced equity rounds vs. convertible notes vs. SAFEs: the essential differences

The biggest difference you need to be aware of is the one between priced equity rounds and both SAFEs and convertible notes.

Convertible notes and SAFEs are fast, easy, flexible, and cheap. Private equity rounds are expensive and time-consuming. SAFEs cost around US$ 10k, and priced equity rounds could set you back US$ 50k or more.

Convertible notes and SAFEs aren’t too different, even though one is debt and the other isn’t. They both convert at a later stage. SAFEs typically convert when the company issues a new round of preferred shares. Convertible notes, meanwhile, can convert under a bunch of different circumstances. It all depends on what you agree on with the investor.

SAFEs also let you raise funds on a rolling basis, allowing for more flexibility with valuation caps. That means you can have multiple rounds, each time setting a different valuation based on your company's momentum. In priced equity rounds, each new fundraising requires you to start the same process from scratch.

However, if you decide to do this, take into account that it leads to complexity with the cap table and dilution. And what does that even mean? It means that, if you go crazy with your founder equity dilution, future investors might just swipe left. Here's how to not lose your skin in the startup game.

These are other examples of differences between priced equity rounds, convertible notes and SAFEs in the most common clauses:

Most common clauses in debt vs equity

Which type of funding should you look for?

Nowadays, convertible notes are mostly a thing of the past. If you’re raising a small amount, like US$ 5M or less, SAFEs are the better option. If you’re lucky enough to raise more, priced equity rounds are your go-to investment vehicle.

Of course, nothing is black and white – there are some exceptions. It’s definitely possible to raise bigger rounds with SAFEs, but it’s uncommon, as dilution can become more significant than you’d like it to be.
As we've mentioned, SAFEs allow you to raise funds on a rolling basis, while priced equity rounds don’t. So when things aren’t going too well, raising a SAFE in between two bigger rounds can be an interesting solution to avoid a down round. 

Whatever people say, don’t let it hold you back from doing your thing. But remember: know very well the basics and measure twice to cut once.

Join a community of high-caliber founders and mentors to support you on your journey: apply.latitud.com

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