Fundraising is arguably the most critical activity undertaken by startups. The quality of the essential elements of a startup—idea, product, team, etc.—are all irrelevant if that startup is unable to fund the enterprise. Another source of difficulty in fundraising for startups is the typical knowledge gap that exists between investors and founders. While founders may spend a few months of the year devoting a fraction of their energy and focus to fundraising, investors live and breathe it all year long. So how do successful founders level the playing field?
To reduce the knowledge gap, founders should start by understanding how investors think. Once they understand how investors are motivated, founders should begin to gain an understanding of the financial instruments involved in these deals, including SAFEs and convertible notes. This is critical even for experienced founders because there are so many different scenarios that can arise during a fundraising round and no founder has personally been through each and every one.
Note: This post focuses on the terms in SAFEs and convertible notes in “convertible rounds.” To learn about equity rounds, see our post on Series A fundraising and our guide on term sheet negotiations.
Convertible instruments: SAFEs and convertible notes
SAFEs and convertible notes are both types of convertible instruments sold by companies to raise money in a convertible round before they have raised any equity financing, or as a bridge round in between equity financings. Because SAFEs evolved from convertible notes, some terms are found only in convertible notes, some are found only in SAFEs, and many terms are still shared.
Terms common to SAFEs and convertible notes
How much will the investor invest? This is referred to as the “Purchase Amount” in a SAFE and the “Principal” in convertible notes.
Discount and/or valuation cap
Since startup investments are considered to be risky, SAFEs and convertible notes often feature a discount or a valuation cap, or both, which entitle investors to convert their investments into a company’s equity at a lower price than later investors in the company would pay for the equity. A discount is usually expressed as a simple percentage that is deducted from the price that other investors will pay. For example, if a Series A price is $1.00/share, then the amount invested in a SAFE with a 10% discount will convert into Series A shares at $0.90/share.
A valuation cap sets a limit on the company’s valuation that will be used to calculate the conversion price of the SAFE or convertible note. If a startup raises money at a higher company valuation than the valuation cap, then the SAFE or convertible note will convert into shares at the lower valuation cap. For example, if a company raises a Series A financing at a $10 million pre-money valuation but an investor has a $5 million valuation cap on a convertible note, then the convertible note will convert into Series A shares at a price determined using the lower $5 million valuation.
When both a discount and a valuation cap are featured, the actual conversion price is the lower result of the two calculations.
Conversion (upon an equity financing)
SAFEs and convertible notes can convert into equity of a company when certain events occur. The most common conversion event is an “Equity Financing” or a “Qualified (or Next) Equity Financing.” This means that if the company raises more than a threshold amount of money in an equity financing, then the SAFE or convertible note will automatically convert into the same type of shares sold in the equity financing.
For SAFEs, conversion is triggered by any equity financing that is, as Y Combinator phrases it, “a bona fide transaction or series of transactions with the principal purpose of raising capital, pursuant to which the Company issues and sells Preferred Stock at a fixed valuation.”
With convertible notes, often the qualifying threshold is set between $500,000 to $3,000,000 depending on the size of the company. Sometimes, an investor can also choose to convert their SAFE or convertible note investment into the equity of a company (usually its common stock) upon the acquisition of the company or when other predefined events have occurred.
Conversion into preferred stock, shadow preferred stock, or preferred and common stock
Ever wonder why there are so many numbered series of Preferred Stock on a company’s cap table, like Series A-1 Preferred Stock, Series A-2, Series A-3, Series A-4, and so on? For a long time, convertible instruments converted into the exact same type of Preferred Stock that was being sold to other investors in an equity financing, with the exact same liquidation preference and other terms. As valuation caps and discounts on convertible instruments became more common, this resulted in a growing problem for companies, known as a “liquidation overhang,” where investors were paying a discounted price per share of stock but receiving shares of stock that were entitled to a full liquidation preference when the company was sold. For example, a convertible note investor with a 20% discount would pay $0.80 per share of Series A Preferred Stock upon conversion, but would receive a share of Series A Preferred Stock with a $1.00 liquidation preference.
To solve this liquidation overhang problem, companies began issuing a combination of full-priced Preferred Stock for the amount of money actually invested by an investor and Common Stock for the “discount” when a convertible instrument converted. For example, if an investor invested $100,000 on a convertible note with a 20% discount, then upon conversion, they would be entitled to 125,000 shares, of which the company would issue 100,000 shares as Series A Preferred Stock (with a liquidation preference of $1.00 per share), plus another 25,000 shares of Common Stock (with a liquidation preference of $0 per share). Eventually, companies began issuing Shadow Preferred Stock in response to the problem, which was an elegant solution of simply creating different series of Preferred Stock with the same general terms but different liquidation preferences for each series based on the price actually paid for the shares.
With Shadow Preferred Stock, the investor who invested $100,000 on a convertible note with a 20% discount would be entitled to 125,000 shares upon conversion, of which the company would issue 125,000 shares as Series A-2 Preferred Stock (a shadow series of the “regular” Series A-1, with a liquidation preference of $0.80 per share). When Y Combinator introduced the SAFE, they adopted this concept of Shadow Preferred Stock. As a result of widespread usage of SAFEs among startups, cap tables with multiple numbered series of Shadow Preferred Stock have become the norm.
Change of control premium
What happens if the company is sold while the SAFE or convertible note is still outstanding? The standard SAFE provision is that investors get their money back. Convertible note investors have negotiated premiums from 0 (get their money back), to 50% (1.5X their money back), or even 100% (2X their money back) in the event of an early exit before an equity financing.
Pro rata rights
Pro rata rights (also known as preemptive rights, participation rights, or rights to maintain proportionate ownership) refer to the right of an investor to invest in a company’s next financing round up to an amount that is usually based on the investor’s then-current ownership of the company. A standard provision in the pre-money SAFE gives pro rata rights to all pre-money SAFE investors in the next equity financing round once they have converted their SAFEs into equity. As a practical matter, many companies would prefer to give pro rata rights only to “major investors” or “major purchasers,” who typically must invest at least a threshold amount of money to qualify as such. Pro rata rights are not a standard provision in the post-money SAFE or traditional convertible notes, which allows for companies to grant pro rata rights more selectively.
Most-favored nation (MFN)
An investor may ask for an MFN right along with their SAFE or convertible note, which means that if a company gives any better terms to any other investors (like a better discount or a lower valuation cap, or pro rata rights), then it must offer those same terms to the investor who has the MFN right. Practically, MFN rights are usually exercised by investors right before conversion of the SAFE or convertible note in an equity financing round, at which time there is certainty that no other different terms will be offered and there is visibility into the “best” terms available.
Convertible note terms
Some terms are found in convertible notes but not SAFEs:
Interest & maturity date
As debt instruments, convertible notes bear interest and have a maturity date. Interest can be simple or compound. A maturity date is the date upon and after which an investor can demand that a company repay the outstanding amount (principal and interest) due on the convertible note. In the startup investment context, it is usually expected that the principal and interest on convertible notes will not be repaid, but instead will convert into equity in the company.
Although it is not very common in the startup investment context, convertible notes may be secured by an interest in specified assets of a company, which may include its intellectual property. A security interest gives a convertible note investor a claim to the specified assets of the company in the event that the company is unable to meet its repayment obligations.
The key innovation of the SAFE is that there is no interest or maturity date in order to reflect the typical Silicon Valley understanding that startup investments are not expected to be repaid. SAFE investments are treated as a prepayment on equity instead of as debt.
As the SAFE has evolved, some features are found in SAFEs but not in convertible notes:
Pre-money vs. post-money SAFE
When the SAFE was originally introduced by Y Combinator in 2013, it was a “pre-money” SAFE. In 2018, Y Combinator introduced the “post-money” SAFE. A key difference between the pre-money SAFE and the post-money SAFE is whether the SAFE investor bears any dilution from subsequent investments other than a priced equity round. A pre-money SAFE investor will share in any dilution from subsequent investments with the existing stockholders of the company. A post-money SAFE investor does not bear any dilution from subsequent investments other than a priced equity round. Each type of SAFE has its own nuanced advantages and disadvantages for startups and investors depending on the specific circumstances of the startup and the manner in which it plans to fundraise.
Getting in the mind of investors
Having a thorough understanding of the terms investors care about and the potential ways in which they can impact their ROI will enable you to negotiate more effectively. Additionally, understanding these terms and how they affect fundraising rounds will make you not only a better fundraiser but also a better overall operator as well. The devil is in the details and you want to strike the optimal balance between attracting investors and safeguarding your business. Whether you’re raising capital with convertible notes, SAFES, or both during a convertible round, or negotiation a term sheet during an equity round, understanding the terms involved is crucial before you move on to begin preparing for the pitch and meeting process.