Why do early stage startups raise via SAFE/Convertible Notes?
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- Ever heard about Convertible Notes/SAFE? What are they and what importance do they holdin early-stage startup ecosystem?
- This week, Khushdeep Sethi, covers all about convertible notes and SAFEs!
Having plunged into the evaluation process for early-stage startups for the last two weeks (we have discussed it here), it’s high time we turn our sails towards investments which is long overdue.
For the past 10 years or so, founders of early-stage startups have been increasingly turning to convertible notes and SAFEs to structure investment rounds, particularly for their first capital raise. But what are convertors? Why not just opt the traditional Priced Equity? What are the primary benefits for founders and their investors to opt for convertible notes and SAFEs? It's important to consider why the convertible notes and SAFEs have made such a big splash in the early-stage financing world.
Convertible Notes
A convertible note is short-term debt that converts into equity. The primary advantage of a convertible note is that it allows founders and investors to postpone the valuation discussion to another day. Convertible notes convert into equity based on the valuation of the company’s next equity financing round. They avoid placing a valuation on the startup, which can be useful particularly for seed stage companies which have not had enough operating history to properly set a valuation and act as a good bridge-capital or intra-round financing options. What is in it for you?
As convertible noteholders, you receive:
1. A creditor's claim to its principal and interest.
2. The right to receive equity of the company under certain specified circumstances.
It usually includes a “valuation cap” — a maximum valuation at which the investment made via the convertible note will convert into equity OR a 'discount on valuation' - where the investment converts to equity at a discounted valuation. This protects the investor against receiving only a minuscule amount of ownership in the company in case the valuation of the future priced equity round gets set so high. More developed startups also use convertible notes as bridge financing to a later-stage equity round or a sale of the company.
SAFEs
The SAFE was introduced by YCombinator and Orrick in 2013 to streamline venture financing for early stage startups. It is a brief investment document that offers a simple way for investors to provide funding to early stage companies. The goal was to avoid the drawn-out negotiations and lengthy paperwork that can often serve to hinder the investment process, by creating standard, pre-agreed terms and conditions that govern the investment.
The core is that investors provide funding to companies in exchange for the right to obtain equity in the company down the road.
A SAFE and convertible note both allow for conversion into equity. The key difference is that SAFEs only allow for conversion into the next round of preferred stock issued by a company in the next priced financing round. On the other hand, convertible notes allow for conversion into the current round of shares or a future financing event where a new series of preferred stock is issued.
It is quite evident that early-stage startups prefer SAFEs and convertible notes over priced equity as it provides them a much more reliable method for raising capital without the Valuation pressure.
At Favcy, we use a slightly modified version of SAFE to raise funds for our early stage portfolio startups. We call them ATFT (Agreement Towards Future Transactions) agreements and offer lucrative multipliers to our early stage investors. For example - if you invest Rs.5L in a startup, at a 2X multiplier, your investment will convert to equity worth Rs.10L(2XRs.5L) at the next valuation. Now if the valuation is Rs.10Cr, for your Rs.5L investment, you get 1% equity.
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