2 Fundamental Questions About Convertible Debt Notes and SAFEs

The Situation

Imagine: you’ve spent the last 18 months developing your widget. You’ve completed early customer discovery, launched version 1.0 of your minimum viable product, and have landed a dozen excited pilot customers. Things are going well. 

Except when you look at your bank account. 

So far, you’ve kept the business running thanks to generous investments from friends and family. You now realize this can’t last. It’s time to raise money from other sources. 

The business is not yet generating revenue, so traditional financing options are off the table. You’ve heard the terms “SAFE” and “CDN” before but have two fundamental questions. 

How do SAFEs and CDNs work? And how could a SAFE or CDN help me? 

Let’s discuss each of these questions in turn. 

Question 1: How Do SAFEs and CDNs Work? 

Commonalities

What do these instruments accomplish? At their core, they enable investors to exchange cash today for an equity stake later. Both the Simple Agreement for Future Equity (SAFE) and Convertible Promissory Note (often referred to as a Convertible Debt Note or CDN) deliver this benefit. This is in contrast to a traditional priced equity round, which requires the company to set a fixed issue price per share. Instead, these instruments “punt” the task of setting a valuation (which can be an expensive and complex task) to a future date. In theory, valuing the firm at that time will be far simpler than it would be today.

The specific terms of the SAFE or CDN will detail the agreement between the company and its investors, including provisions that define the conditions upon which each investor’s capital will convert into an equity stake in the firm. This conversion typically occurs when a qualifying event takes place. Common examples include the sale of the company, an initial public offering (IPO), or a priced equity financing round. 

Other key terms generally include a valuation cap and/or a discount. The valuation cap defines the largest price at which the investor’s capital would convert into equity if a qualifying event were to occur. It is either expressed as a “pre-money” or “post-money” valuation, which indicates whether the current round is included in the given valuation figure. A discount is typically expressed as a percentage of the “price” set by the future qualifying event (a “20% discount”, for example). It is common for both functions to be present although this is not always the case. 

Differences

While the two instruments are very similar in basic function, the core distinction revolves around two simple concepts: interest and maturity. 

A SAFE generally does not include provisions for an interest rate or term length and is generally not treated like debt for legal and accounting purposes. In contrast, a CDN is debt for legal and accounting purposes, and typically specifies a term for the investment (24 months, for example) with an interest rate (6-8%, for example). During the life of the investment, the initial investment earns the specified rate of interest. Like a traditional loan, this increases the outstanding balance over time. If the CDN has not converted at the conclusion of the term (maturity), depending on the terms of the CDN, one of three things typically happens, depending on the terms of the CDN: (1) the total balance of the investment (principal + interest earned) can be converted into equity, (2) the outstanding balance can be repaid in cash, or (3) the parties can agree to leave the note outstanding for future conversion. 

Question 2: How Could a SAFE or CDN Help Me?

Both CDNs and SAFEs offer several benefits to both founders and to early-stage investors. In this section, we explore the benefits of both methods, as well as individual methods. 

Both SAFEs and CDNs

There are 3 key benefits applicable to both SAFEs and CDNs:

Relative Speed

Both SAFEs and CDNs are far simpler to create than the typical priced round issuance and can thus be issued more quickly. New rounds can often open within a few days, enabling founders to complete funding rounds without wading through oceans of paperwork and legal fees.

Delay Company Valuation

Both methods delay the onerous task of valuing the company, which is especially difficult if the firm is pre-revenue. This flexibility is critical to securing early partnerships. It also enables the firm to focus its short-term resources on expanding operations to maximize growth.

Control of Control

Since investors via either of these methods do not immediately gain shares of company stock, the issue of control rights can be delayed until conversion. This allows company leadership to remain fast and lean in the critical early years. 

SAFE

A hallmark benefit of a SAFE note is its simplicity (it is, after all, called a Simple Agreement for Future Equity). The SAFE was originally introduced by Y Combinator, a well-known startup accelerator, in 2013, as a trimmed-down alternative to a priced round or CDN. It is very short, is generally considered to be very founder-friendly, and can be quickly drafted with minimal upfront legal fees. Focal negotiation points are the valuation cap and/or discount, and most early-stage investors are familiar with the process.

CDN

One unique benefit of a CDN is that it generally receives higher preference in the capital stack than equity holders do, as it is a form of debt. In addition, the maturity schedule provides a unique opportunity for scheduled re-engagement and possible renegotiation as compared to a SAFE, which does not place any time bounds on the investment. Additionally, though SAFEs are relatively common nowadays, convertible debt notes have been available to investors for far longer and are often cited as more investor friendly. 

Conclusion

While there are many ways to finance an early-stage venture, choosing a SAFE note or CDN may be the right choice for your business or investment. However, every scenario is unique, and it is critical to involve legal counsel in the process as early as possible.