Optimizing Early Seed Financing: SAFEs vs Convertible Notes for Start-ups

When it comes to raising early seed funds for a tech start-up, many entrepreneurs and investors face the decision between issuing convertible notes or using SAFE agreements. This article aims to provide a comprehensive guide, discussing the pros and cons of each approach, and offering actionable advice on structuring the financing to ensure a smooth and beneficial outcome for the founders and investors in future rounds.

Understanding Convertible Notes vs SAFE Agreements

Convertibles and SAFEs (Simple Agreement for Future Equity) are both financial instruments used in early-stage financing, designed to convert into equity at a predetermined valuation in the future.

Convertibles offer more flexibility as they can be issued with various terms and conditions, making them a popular choice among investors. However, they can complicate the financing process, especially when multiple rounds of funding are involved. SAFEs, on the other hand, are simpler instruments, standardized, and easier to manage. They are more suitable for friends and family rounds or early seed financing.

Why Use SAFEs for Friends and Family Rounds?

For a US-based start-up raising seed funds from friends and family, SAFEs are generally the preferred choice. Here are some reasons why:

Persimlicity: SAFEs are easier to understand and manage compared to convertible notes. They require less paperwork and fewer terms to negotiate, reducing the administrative burden on both the company and investors. Standardization: SAFEs tend to be more standardized, which means they are widely recognized and accepted by investors and legal advisors. This simplifies the fundraising process and minimizes discrepancies in interpretation. Integration: SAFEs are compatible with other funding instruments, making it easier to close multiple rounds of financing without the complexity associated with convertibles. This is particularly beneficial when the company’s funding history is transparent. Less Mistakes: SAFEs are less prone to errors since they have fewer complex terms compared to convertible notes. This reduces the risk of misunderstandings or disputes during the fundraising process.

Key Structural Elements for SAFEs

When structuring a SAFE agreement, it is crucial to consider the discount and valuation cap offered to investors. These elements play a significant role in determining the equity value of the convertible shares when the company raises a qualified round of funding.

Discount - A Modest Standard Discount

A common practice is to offer a modest standard discount, such as 20%. This discount ensures that the investors receive a better valuation than the latest round of financing, thereby rewarding them for their early investment. A 20% discount is generally considered appropriate and aligns with industry standards without being too generous.

Valuation Cap - No or a Moderate Valuation Cap

When it comes to the valuation cap, it is important to strike a balance between rewarding investors and protecting future equity distribution. Setting a low valuation cap, such as $2 million, is likely to be too restrictive and could result in investors giving up too much equity if the company performs exceptionally well. Conversely, setting a high valuation cap, such as $8 million or $10 million, might be less relevant, as it won’t influence the outcome if the company doesn’t reach that valuation in the next round.

For tech start-ups, a moderate valuation cap is often a good choice. If the valuation cap is too low, say $2 million, it means investors will convert their SAFEs into equity at a higher price per share, which could make future fundraising rounds challenging. On the other hand, setting a high valuation cap, such as $8 million or $10 million, could signal to investors that you have an overly high opinion of the company’s potential or unrealistic valuation expectations.

As a general guideline, if you expect the company to perform exceptionally well, setting a higher cap may not be necessary. However, if the company is in a high-growth industry, a moderate cap within the range of $5 million to $7 million could be a more prudent choice to ensure a balanced equity distribution in future rounds.

Considerations for Convertible Notes

For those who prefer to use convertible notes, it is important to consider the following:

Interest Rate: A low-interest rate, such as 4% to 6%, is common and reduces the financial burden on the company. Higher interest rates can be detrimental to early-stage companies with limited financial resources. Valuation Cap: Similar to SAFEs, setting a moderate valuation cap is advisable to balance equity distribution and investor reward.

It is crucial to work with experienced legal counsel to ensure that the chosen financial instruments align with your specific business needs and strategic goals. A well-structured agreement can help protect your interests and set the stage for future financing rounds.

Conclusion

When raising early seed funds, choosing between convertible notes and SAFE agreements depends on various factors, including the company's specific circumstances and the comfort level of the investors. For friends and family rounds or early seed financing in a tech startup, using SAFEs offers simplicity, standardization, and fewer administrative challenges. By structuring the agreement with a modest discount and a moderate valuation cap, founders can ensure that they are in a good position to raise future rounds of financing on favorable terms.