Simplifying SAFE Agreements and Convertible Notes


Startups cannot utilize equity funding with the same ease that larger companies; it is nearly impossible to convince people to invest in an organization with no valuation statistics or performance-based metrics. That being said, there are several different avenues that can be taken to secure seed funding. Two of the more popular options are SAFE agreements and convertible notes. Both have their relative advantages and disadvantages, so how entrepreneurs choose between the two will depend on their strategic long-term funding goals. This article endeavors to look at both these instruments closely in order to highlight their merits and demerits.


The acronym "SAFE" stands for "Simple Agreements for Future Equity".

SAFE notes are best understood as legal instruments used by startups to gather seed funding. They are not considered to be debt instruments but instead are treated in a manner similar to warrants. They're best understood as agreements which create future equity. The agreement itself is a relatively simple 5-page document, which allows investors to convert their funding into equity in the future. SAFE agreements solve the problem of raising money at the inception of a startup when assigning a value to it is challenging.


Unlike SAFE notes, convertible notes are debt instruments. The premise behind a convertible note is that the initial cash investment will be repaid in the form of equity at some point in the future. The convertible note has a few key features. Firstly, it has a valuation cap. This sets the ceiling for valuation at the point of note conversion. Secondly, they also offer discount rates to initial investors. This acts as an incentive to early investors. Thirdly, convertible notes have a set interest rate. Since the money can be likened to a loan, it accrues interest which is typically paid back in the form of equity. Finally, they also come with a maturity date, which refers to the date by which the company becomes liable to repay the investor.


SAFE agreements and convertible notes have a few things in common.

They are both classified as convertible securities. This basically means that both the investor and the startup intend to convert them into equity. Both instruments seek to attract future investors by offering discounts and valuation caps which apply to future equity funding rounds.

Typically, early exit/payout options are made available to investors in the event of an acquisition in both cases. Given the similarities between convertible notes and SAFE agreements, it is natural to wonder about the utility of SAFE agreements. SAFE agreements came about in response to the problems associated with convertible notes.

At one time, the convertible note was one of the most commonly used devices to raise money for startups. This is not to say it didn't come with its own set of issues. The premise of a convertible note is that it will be converted into equity in a future round. If, however, the future round never happens, the convertible note turns into a cash debt. For most startups, being liable to pay the original amount plus interest in cash would most certainly lead to bankruptcy. Additionally, valuation caps and discounts can prove to be tricky. Although they can and should be used to attract investors, overestimating these values can negatively impact future funding rounds. Finally, convertible notes are notoriously complex from the legal point of view and will almost always require sound legal advice, which might be an added expense for the startup.

SAFE notes were launched by Y Combinator in 2013, and the general consensus is that as financial instruments, they're much simpler than convertible notes. From the point of view of the startup, they remove two of the most problematic elements of the convertible note- the maturity date and the interest rate. This explains why these are agreements rather than notes. The final document spans only 5 pages and is available for free on the Y Combinator website which makes it a more viable option for those seeking to avoid hefty legal fees.

SAFE notes come with the added advantage of "high resolution fundraising". This technique allows startups to close with each individual investor once they are ready to sign- there is no need to wait for a simultaneous closing with all investors. SAFE notes safeguard business equity for a longer period of time as compared to convertible notes. Since there is no maturity date, there is no fixed time by which the payment is due. It is therefore unsurprising that SAFE notes have been very well received and it is likely that most investors will be familiar with them.

Given the advantages outlined above, it might seem like SAFE notes have no disadvantages whatsoever, but this is obviously not true. There is always a downside to using any standardized contract, and the SAFE note is no exception. As mentioned earlier, SAFE notes are not debts-they are merely promises of future equity. In the event of liquidation, a convertible note, being a debt, ranks higher on the priority list when it comes to repayment of liabilities. The SAFE note, although placed ahead of common equity holders, does not enjoy the same priority as a secured debt. This is a major drawback to the investor, who stands a realistic chance of never seeing their money again.

In conclusion, when it comes to deciding between a SAFE note and a convertible note, there are no right answers. A lot of entrepreneurial circles would advocate in favor of SAFE notes due to their simplicity, flexibility, and overall economy. However, nobody knows your business the way you do- so it's important to do your due diligence and find the perfect fit you're your needs. Ultimately, what's important is finding an arrangement that works for both the investors and the company.

Disclaimer: This article is made available for educational purposes only, to give you general information and a general understanding of the law, not to provide specific legal advice. By using this article, you understand and acknowledge that no attorney-client relationship is formed between you and The South Texas Business Lawyers, nor should any such relationship be implied. This article should not be used as a substitute for competent legal advice from a licensed professional attorney in your state.

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