When it comes to raising early-stage funding, convertible notes and SAFEs (Simple Agreements for Future Equity) have become popular tools for startups. Both offer founders a way to secure investment without immediately giving up equity or setting a valuation. However, each has its own structure, benefits, and potential downsides. As an investor, I’ve seen how choosing the right funding agreement can impact a startup’s control, flexibility, and growth prospects. Here’s a breakdown of convertible notes and SAFEs to help founders make an informed decision.

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What Are Convertible Notes?

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A convertible note is a type of debt instrument that allows startups to raise funds in the form of a loan that later converts into equity. The conversion usually happens during a subsequent funding round, when a valuation is set, converting the loan into shares at a discount or with interest.

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How Convertible Notes Work:

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• Loan Agreement: A convertible note starts as a loan, with terms including interest rates and a maturity date.

• Conversion to Equity: When the startup raises a priced funding round (often Series A), the note converts into equity. Investors typically receive a discount on the share price or additional equity as compensation for their early support.

• Cap and Discount: Convertible notes often include a valuation cap, which sets an upper limit on the share price during conversion, and a discount rate, which provides investors with a lower share price than future investors.

 

Advantages of Convertible Notes:

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• Delayed Valuation: Convertible notes let founders raise funds without setting a valuation, which can be challenging for early-stage startups.

• Investor Security: Since it’s a loan, investors have the option to be repaid if the startup doesn’t convert the note before the maturity date.

• Incentives for Early Investment: Convertible notes’ cap and discount provisions reward early investors with favorable terms.

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Potential Downsides:

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• Interest and Maturity Dates: As debt, convertible notes accrue interest, and the loan must be converted or repaid by the maturity date. This can create pressure for founders, especially if a new funding round hasn’t been secured.

• Complexity: Convertible notes often come with more detailed terms than SAFEs, which can complicate negotiations and take more time to finalize.

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When to Consider Convertible Notes:

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Convertible notes can be a good option for startups that anticipate raising a priced round soon and want to offer investors some security through debt terms. They’re often used by startups that have a clear path to raising additional funds in the near term.

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What Are SAFEs?

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SAFEs, or Simple Agreements for Future Equity, were developed by Y Combinator as a founder-friendly alternative to convertible notes. Unlike a convertible note, a SAFE is not a debt instrument; it’s an agreement that converts to equity in a future funding round, but without interest or a maturity date. This structure gives founders more flexibility by removing the pressure of repayment.

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How SAFEs Work:

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• Future Equity Agreement: A SAFE provides investors with a right to equity when the startup raises its next funding round. There’s no interest rate or debt component, as it’s not considered a loan.

• Cap and Discount: Similar to convertible notes, SAFEs can include a valuation cap and a discount, ensuring early investors receive favorable terms upon conversion.

• Conversion on Trigger Event: A SAFE converts to equity when a triggering event occurs, typically the next equity financing round. Until then, there are no obligations for repayment or interest.

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Advantages of SAFEs:

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• No Repayment Pressure: Without a maturity date or interest rate, SAFEs don’t impose repayment obligations, allowing founders to focus on growth without debt pressure.

• Simplicity and Speed: SAFEs are generally simpler to negotiate and require fewer legal provisions than convertible notes, making them faster to execute.

• Founder-Friendly Terms: Designed to be straightforward, SAFEs provide flexibility for startups without the financial burden of a loan.

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Potential Downsides:

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• Less Investor Protection: Since SAFEs lack debt terms, they’re riskier for investors. This may deter some investors, particularly if they’re looking for security on their investment.

• Potential for Overlapping Conversions: Without a maturity date, SAFEs may accumulate across multiple funding rounds, creating potential dilution issues in the long term.

• Uncertainty with Timing: Investors have to wait for an equity round to occur before their SAFE converts, which could be delayed if the startup doesn’t raise funds as expected.

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When to Consider SAFEs:

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SAFEs are ideal for startups that want a streamlined, flexible funding option without the pressure of debt. They’re commonly used by startups raising initial funds from angel investors or in early-stage accelerator programs, where simplicity and founder-friendly terms are valued.

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Key Differences Between Convertible Notes and SAFEs

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Understanding the distinctions between these agreements can help you choose the best fit for your startup’s needs. Here’s a comparison of the primary differences:​

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