Why Are Tech Companies Opting for Convertible Notes and SAFE Notes?
Convertible notes and SAFE notes have become increasingly popular among tech startups and companies raising early-stage funding. These documents offer several advantages that make them a favored choice for both startups and investors. Let's delve into why they are so widely used, what makes them beneficial, and why tech companies are turning to these financial instruments.
Lightweight and Cost-Effective
Convertible notes are lightweight, easily understood documents that a company can enter into without incurring significant legal or accounting expenses. This means that early-stage companies can quickly access necessary capital without being burdened by complex paperwork that might limit their future growth and flexibility. These notes serve as placeholders or advance bookings for participating in a larger funding round in the future.
Safe notes, a more recent and streamlined alternative to convertible notes, follow a similar principle. They are designed to provide the same benefits with even greater simplicity and ease of use, especially in rapidly evolving tech environments where speed is of the essence.
Why Not Priced Rounds?
Traditional priced rounds, while offering more significant benefits to investors, are often more expensive and time-consuming. These rounds typically involve detailed legal and financial due diligence, which can be costly and time-consuming for early-stage companies. Moreover, the benefits that these rounds offer, such as liquidation preferences and anti-dilution provisions, are often not advantageous for early investors who may lack the sophistication or resources to fully appreciate and leverage these perks. Additionally, early-stage companies are often not in a position to secure substantial funding or active participation from investors that would justify the effort required for more complex funding documents.
Given the high risk and uncertainty associated with early-stage tech ventures, it often doesn't make sense to overcomplicate the funding structure now if it may not be relevant in the long run. This sentiment is encapsulated in the adage, "You can't fix a leaky roof when the rain is pouring down." By using convertible notes, startups can secure capital without the risk of prematurely limiting their options for future financing.
Company-Favorable Terms
Convertible notes tend to be more company-favorable, especially for startups that have some bargaining power. This quality makes them a preferential choice for companies that are in a position to negotiate the terms. Convertible notes are generally seen as a business norm, widely understood and accepted in the tech industry. Even if an investor agrees to participate, they have a basic understanding of what they are signing up for, which can help align expectations and reduce miscommunication.
The use of convertible notes also allows for flexibility between rounds. During interim funding gaps, smaller amounts of money can be injected through these notes to keep the company running until the next major funding round. These notes typically adopt the terms and characteristics of the next funding round, ensuring that investors know they will receive similar terms and protections as later investors.
For added security, investors can negotiate for most favored nation (MFN) clauses or other side letter agreements to ensure they are not disadvantaged relative to other investors. These clauses help prevent “end runs” that might otherwise squeeze out minority investors.
Conclusion
Convertible notes and SAFE notes continue to be preferred funding strategies for tech companies looking to attract capital in a cost-effective and flexible manner. These documents provide a balance between the simplicity needed to quickly secure funding and the security required to protect the interests of both investors and the company in the long term. As the tech industry continues to evolve, the use of these funding instruments is likely to remain a significant aspect of the startup ecosystem.