Key Takeaways:

  1. Convertible notes are debt that converts into equity during a future round.

  2. SAFE notes are equity agreements with no repayment or maturity.

  3. Equity financing requires setting a company valuation upfront.

  4. Convertible notes offer more protection for investors than SAFE notes.

  5. Each method is suitable for different stages of a startup's growth.

Choosing the right financial method is a crucial decision for any startup, especially during its initial stages. Typically, startups have three main financing options—equity financing, SAFE notes, and convertible notes—and each offers unique advantages and disadvantages. Understanding how they differ can help founders make informed decisions and negotiate better terms with investors. 

What Is a Convertible Note?

A convertible note is a type of short-term debt that converts into equity at a later stage, usually during the next round of funding. For startups, convertible notes are a flexible way to raise initial capital without setting a valuation on the company. 

Financing through convertible notes typically happens in 3 stages.

  1. Debt Agreement: Initially, the convertible note functions as a loan. The investor provides capital in exchange for a promissory note indicating the startup’s obligation to repay.

  2. Conversion to Equity: At a future equity financing round, the note converts into shares of the company, often at a discounted price or with a valuation cap. This incentivizes early investors by giving them more favorable terms.

  3. Interest and Maturity: Convertible notes typically accrue interest and have a maturity date, meaning if they do not convert by a certain time, they must be repaid.

What Is a SAFE Note?

A SAFE (Simple Agreement for Future Equity) note is an agreement between an investor and a company that provides the investor with the right to obtain equity at a future financing round. The investor provides capital upfront in exchange for the right to convert their investment into shares during the next equity financing round. 

Unlike convertible notes, SAFEs are not debt and do not accrue interest or have a maturity date. Therefore, there is no obligation for the company to repay the investment if the conversion does not happen.

That being said, SAFE notes often come with a valuation cap, which limits the maximum price at which the investment can convert into equity. Sometimes, they may come with a discount, which provides a percentage reduction off the share price during the next financing. 

What Is Equity Financing?

Equity financing involves raising capital by selling shares of the company to investors. This form of fundraising is common during the later stages of a startup's growth, where the company’s valuation is established. Key aspects of equity financing include:

Unlike convertible notes and SAFEs, equity financing requires setting a company valuation upfront. Equity investors typically receive certain rights, such as voting power or board seats, depending on the terms negotiated.

Convertible Notes vs. SAFE Notes: What’s the Difference?

While both convertible notes and SAFE notes allow startups to raise funds without setting a valuation, there are some important differences:

  • Debt vs. Equity: Convertible notes are debt instruments that convert to equity, whereas SAFE notes are equity agreements from the start.

  • Interest and Maturity: Convertible notes accrue interest and have a maturity date, while SAFE notes do not.

  • Risk Level for Investors: Because SAFE notes lack a repayment obligation, they may be riskier for investors compared to convertible notes.

Equity vs. Convertible Notes: Which Is Right for Your Startup?

Choosing between equity financing and convertible notes depends on several factors:

  1. Stage of the Startup: Early-stage startups often use convertible notes to delay setting a valuation, while later-stage startups may use equity financing when the company’s worth is more established.

  2. Investor Preferences: Some investors prefer convertible notes for their debt-like structure, while others may prefer the direct ownership associated with equity financing.

  3. Company Cash Flow: If the startup has unpredictable cash flow, convertible notes may pose a risk due to the repayment obligation if the notes do not convert.

Pros and Cons of Convertible Notes

While convertible notes are an excellent source of financing for businesses in the initial stages, there are advantages and disadvantages to this method. Some of the advantages of using convertible notes are:

  • Delays valuation: Useful for early-stage startups to avoid setting a valuation too early.

  • Incentivizes early investors: Provides discounts or caps as a reward for taking early risks.

  • Quick to implement: Easier to negotiate and execute than equity financing.

On the other hand, in the long term, convertible notes come with certain risks and complications. Some of the disadvantages of relying on convertible notes are given below.

  • Repayment risk: If the notes do not convert, the startup must repay the debt.

  • Accrues interest: Increases the total amount owed if the note does not convert promptly.

  • Potential for complex terms: Multiple notes with different terms can complicate future fundraising.

Pros and Cons of SAFE Notes

Compared to convertible notes, SAFE notes may seem like a better choice for risk-averse entrepreneurs who do not want to take the risks of future debts or legal complications. Below are some of the benefits of using SAFE notes.

  • Simplifies the fundraising process: No interest, no maturity, and fewer legal complexities.

  • Avoids debt obligations: No risk of having to repay the investment.

  • Incentivizes early investors: Offers valuation caps and discounts like convertible notes.

While SAFE notes may seem like a better option for entrepreneurs, investors may not be willing to finance the startup through this method for various reasons such as:

  • Less investor protection: Higher risk for investors due to the absence of debt features.

  • Potential dilution: SAFE notes can lead to significant dilution during conversion if not carefully managed.

  • May deter some investors: Some investors prefer traditional equity or debt structures.

Pros and Cons of Equity Financing

Equity financing is perhaps a more commonly used method of financing compared to SAFE notes or convertible notes. It provides more security for both investors and entrepreneurs alike. Some advantages of equity financing are:

  • Long-term investment: No need for repayment; investors are aligned with the company’s growth.

  • Clear ownership structure: Provides investors with equity and potentially rights such as voting power.

  • Sets a company valuation: Useful for startups with established traction and growth metrics.

While the advantages of equity financing are plenty, it still has certain drawbacks, some of which are given below.

  • Dilutes ownership: Existing shareholders' equity is reduced as new shares are issued.

  • Complex and time-consuming: Requires legal agreements, valuation processes, and potentially investor negotiations.

  • Upfront valuation risk: May undervalue or overvalue the company at an early stage.

When Should Startups Use Convertible Notes, SAFE, or Equity?

Ultimately, the right method of financing would depend on the nature of the startup, the stage it is currently in and what challenges it is currently facing. 

For instance, convertible notes may be ideal for early-stage startups seeking quick capital without setting a valuation. It can be useful for seed rounds or bridge financing before a major equity round.

Meanwhile, SAFE notes are suitable for very early-stage startups needing simplicity in fundraising. SAFEs can be attractive when speed and ease outweigh concerns about investor protection.

Finally, equity financing is best for later-stage companies with more predictable valuations. Equity is appropriate when a startup is ready to offer investors a share of ownership and rights.

Final Thoughts

Understanding the differences, benefits, and risks associated with choosing a financing method will help entrepreneurs make informed decisions about raising funds. For this reason, it can be helpful to seek legal counsel to ensure you understand the legal risks associated with each financing method, and how to stay compliant with any regulation.

If you need further assistance, reach out to startup lawyers through UpCounsel to get expert guidance. 

FAQs

Are SAFE notes a liability or equity?

SAFE notes are equity agreements, not debt liabilities, as they do not require repayment.

Why do investors prefer convertible notes?

Convertible notes offer some investor protection due to their debt structure, including interest and a maturity date.

Is convertible debt safer than equity?

Convertible debt provides more investor security because it functions as a loan before converting to equity.