A Guide for Start-Ups: Understanding the Key Differences Between Convertible Notes and SAFEs

13 Dec A Guide for Start-Ups: Understanding the Key Differences Between Convertible Notes and SAFEs

One of the first questions that start-up companies need to consider when preparing for seed financing is how they will structure the financing transaction with their investors. If the start-up company is a private Ontario or federal corporation, the most popular financing instruments are typically: (i) convertible promissory notes, also known as “convertible notes”; and (ii) simple agreements for future equity, also known as “SAFEs”.

Note that these instruments are not to be confused with “convertible bonds” which are sometimes used by more established businesses or reporting issuers (i.e., companies that have filed a prospectus) or with “convertible debentures” which are sometimes used by later-stage companies seeking a larger investment and where the parties prefer a more structured debt-like instrument.

 
Understanding the Basics: Convertible Notes and SAFEs

Convertible notes are a valuable tool for raising modest amounts of capital. They are debt securities that can convert into the issuing company’s equity securities at a later date, either at the option of the noteholder or upon the occurrence of certain triggering events such as a subsequent equity financing or sale of the company. Convertible notes are often seen as “deferred equity investments” because investors typically expect the notes to convert into shares of the same class (generally preferred shares) that are sold to the first institutional investor(s), rather than receiving a cash repayment of the principal and accrued interest.
 
Compared to formal equity financings (often called “priced rounds”), convertible notes offer start-up companies a cost-effective way to secure funds for their ongoing business expenses and operations as this approach often delays other complex elements of a priced round, such as determination of valuation and formal due diligence. It also simplifies legal drafting and negotiation, thereby reducing legal fees and other professional costs. Start-up companies frequently issue convertible notes to raise modest sums during their early stages or as a bridge financing to a priced round in the future.
 
However, it’s important to note that while convertible notes can allow investors to access the equity of emerging companies at a discounted price, they may offer very few rights and protections to investors. Noteholders typically have a creditor’s claim to the principal and accrued interest of the convertible note and a floating right to receive equity only under specific circumstances.
 
Some key provisions in convertible notes include:

• Discount rate: This feature usually offers a discount on conversion price of the principal and accrued interest into equity to encourage and reward early-stage investment.
• Valuation cap: This mechanism effectively provides investors with a minimum percentage of the company’s equity, regardless of the actual valuation achieved in the next priced round.
• Security: Investors may secure their investment against the company’s property, for instance by way of a general security agreement. 
• Most favoured nation: If another investor receives more favourable terms, the convertible note will be amended to incorporate those terms.
• Maturity date: This is the date when the principal and accrued interest become due if a triggering event for conversion has not occurred.
• Financing threshold: This defines the minimum size of financing by the company needed to trigger the conversion of the note.
• Interest rate: The set rate of interest and the conditions for when the interest becomes payable.
• Triggering events: These are events that trigger the conversion of the convertible note into equity. The most common triggers are a subsequent equity financing or certain types of corporate transactions (e.g., amalgamation or sale of the company). Ideally, the convertible note should have provisions for dealing with situations where the maturity date arrives before a triggering event has occurred such as optional conversion at the election of the noteholder.

An Alternative Approach: Simple Agreements for Future Equity (SAFEs)

If a start-up company does not want to put itself into a position where it may have to repay a convertible note in cash, SAFEs are often an attractive alternative. Like convertible notes, SAFEs usually contain provisions concerning various triggering events, discount rates, valuation caps, and “most favoured nation” clauses, among other provisions. However, SAFEs differ in significant ways:

• SAFEs are not debt instruments; the holder simply receives the right to convert the SAFE into equity of the issuing company upon certain triggering events.
• SAFEs do not create obligations to repay the investment in cash or to pay interest, and they lack a maturity date.
• SAFEs are generally more cost and time-efficient, with simpler and more consistent terms.
• SAFEs typically offer investors the right to convert their investment into equity at a better price-per-share than that offered to subsequent investors in a priced round, as an incentive and reward for investing early in the business’s life cycle.

 
Making the Right Choices for Seed Financing

Financing options for start-up companies in Ontario are complicated and heavily regulated. In selecting the appropriate financing instrument, it is essential to understand both the legal and financial long-term obligations and implications before evaluating available options.

At R&D LLP, we thoroughly review all the critical nuances relating to your business to help you make educated choices regarding the type and structure of financing. We then negotiate investment deals to provide the capital necessary for the growth of your business venture while minimizing risks and maintaining flexibility. If you are interested in exploring convertible notes or SAFEs as an investor or a start-up company, we invite you to schedule a strategy session with us to discuss the available options.