The Choice Between SAFE, Convertible Note & Equity is as Important as the Terms
As an early-stage angel investor, I see dozens of pitches each month. The deals are split roughly equally between SAFEs, convertible notes, and equity.
When I ask founders why they picked one over the other, the usual answer is “It was easiest” or “It’s what our lawyer told us to do.”
What is often missed is that the financial instrument is as important to investors as the deal terms and can have a huge impact on the company’s success. The 3 different financial instruments used in venture investing offer trade-offs in simplicity, taxation, and control.
It’s important to understand the instruments and choose the best one in each funding round.
What is Common Equity?
As a founder, you hold common equity. Your employees, executives, and advisors get common equity (or options to purchase common equity). This is the basic form of stock in a company. When you buy stock in Netflix or Tesla on the stock exchange, you’re buying common equity.
But investors don’t want common equity. We want Preferred Shares which give us rights and protections not included in common equity.
What is Preferred Equity?
As outside investors, we typically request/demand conditions such as:
- Liquidity preference: in an exit, we get paid back our investment (or some multiple of it) before common shareholders get any payout
- Board seat or observer rights: we get a representative on the board of directors, or at least the right to attend all board meetings
- Information rights: we get regular financial updates
- Participation rights: we get the right to buy shares in future rounds
Since decision-making is by a majority vote of the shareholders and the founders own a majority of the shares, the only way to guarantee these rights is to have a separate class of shares.
Preferred Shares Class A (Series A) is the first round of preferred shares. Preferred Shares Class B is the second. Since different rounds of investors can be in conflict with each other, each round of funding gets its own separate share class with a different price and different rights, and separate voting.
While there are good templates such as Series Seed that can make it easy to offer preferred shares, it’s usually a long process involving expensive lawyers on both sides.
The stock purchase agreement itself runs about 25 pages. It has to be accompanied by an amended certificate of incorporation and voting agreement, an investor rights agreement, a right of first refusal agreement, and a list of disclosures. In total, there are around 100 pages of legal crap that have to be agreed upon. Most of it’s boilerplate, but more often than not includes serious mistakes that have to be found and corrected.
In addition to your own legal fees of about $10K, the startup may be required to pay the legal fees of the lead investor, too. It can take a month of back and forth between lawyers and investors before everyone is satisfied.
If this is a big round with a big investor, preferred shares will be the only choice. But if I want to write you a check for $10K as an angel investor, we need a shortcut. This is why early rounds frequently use a convertible note or SAFE instead.
What is a Convertible Note?
Rather than buying stock from an early-stage startup, I hand them a check and we call it a loan until the Series A funding round. At that time, my check is applied to purchase the preferred shares along with the other investors. It’s like pre-purchasing shares.
Since I want to buy equity, why are we calling this a loan?
- To accountants (and the IRS), financing is either purchase of equity or a loan. Since I’m not buying equity yet, it has to be a loan.
- Loan documents are simple. I give you money, you agree to repay it by a certain date with interest. That’s it.
- A loan offers me some basic protections. While I don’t have shareholder voting rights, you can’t pay out shareholders without paying me first.
The convertible promissory note is a standard loan document with a special provision: when the company sells stock to other investors, the loan amount is applied to the purchase of the stock.
Legally it’s a loan. The paperwork says it’s a loan. The accountants put it on the books as a loan. The IRS considers it a loan (a problem we’ll get to later). It has a maturity date and an interest rate like a loan. It’s not a loan.
Though it purports to be a loan, no startup in the history of startups has ever repaid it. In fact, a convertible note includes a provision that prevents you from paying it back. Ignore what most of the document says — this is a holding device to purchase stock.
The document is only 10–15 pages, most of which are irrelevant loan repayment details. You can generate a convertible note agreement on Cooley Go in a couple of minutes.
If I simply accepted whatever terms you negotiate with the next round of investors, the convertible note would be trivially easy. But since I’m investing now when you’re just getting started, I don’t want to pay the same price as investors in Series A, which might be years away.
If I think your startup is worth $10M now, I want to purchase the stock at the $10M valuation rather than the $50M valuation you may have two years later. But if you do a funding round 6 months from now at $5M, then I want the $5M price. This is called a valuation cap. I pay the negotiated Series A price up to the valuation limit.
The other option is a discount on the valuation. A discount alone may be acceptable if the Series A is imminent, but many investors including me won’t invest in a convertible note without a valuation cap. A 20% discount on the $50M valuation two years from now hardly compensates me for the risk I’m taking now.
Because the convertible note is a loan, it has a maturity date and an interest rate. However, no payments are made. The full amount, including accrued interest, is due at maturity, so there needs to be an equity funding round prior to that deadline.
If you think a convertible note is an overly complicated way to pre-pay for stock, you’re right.
What is a SAFE?
What investors like me really want is a simple way to purchase equity now while leaving the docs for later. So the folks at Y-Combinator invented the “Simple Agreement for Future Equity”. The SAFE runs only 7 pages and is not supposed to be modified.
Unlike a convertible note which purports to be a loan, the SAFE states that it is the purchase of equity. While the IRS has not made a ruling, since the SAFE is clearly not a loan, a strong case can be made that it must be equity and therefore eligible for the huge tax benefits of purchasing equity.
Like a convertible note, the SAFE has either a valuation cap or a discount, or the option to take the best deal any other investor negotiates. Since it’s not a loan, it has no maturity date and pays no interest.
The original SAFE was great for accelerators and startups, but for complex reasons I won’t get into, it sucked for investors and many refused to use them. An updated version called the Post-Money SAFE corrected the issues and is gaining wide acceptance.
Tax Benefits of Investing in Startups
It’s impossible to understand why investors want preferred shares without a quick mention of tax law. I’m not a lawyer or an accountant, so I’ll keep it simple.
The biggest benefit, and it’s insane, is that if I purchase stock in a startup and hold it for at least 5 years, I pay NO federal income tax on the gains. NONE. Zero. Zilch.
But that 5-year clock is critical. If the business is acquired in 4 years and 11 months, I have to pay capital gains taxes (24%). If I hold the stock for less than 1 year, I have to pay full income tax (37%).
And if the company fails, like 90% of my investments will, I get to write off the loss against income instead of capital gains. Take my word that’s very useful.
These benefits only apply to equity in a US-based C-Corp. They do not apply to debt. Convertible notes only count once the loan has converted to stock. And that’s a big problem. The conversion needs to be quick.
The SAFE claims to be equity and eligible for the tax benefits of purchasing equity, but without actually owning equity. The IRS has not ruled on the matter, leaving investors on edge about how our SAFE investments will be taxed.
Understanding the Trade-Offs
The choice between preferred equity, convertible note, and SAFE is a trade-off between simplicity, taxation, and control.
Equity offers huge benefits to investors for taxation. SAFEs may offer the same benefits, but nobody is sure how the IRS will rule, so investors are far more comfortable once the SAFE has converted to preferred equity. Convertible notes are problematic for taxation, and we’ll demand as short a maturity date as possible.
Control is the tricky element to evaluate. A SAFE offers investors no voting rights, no board seat, no oversight of the company. Fine for an accelerator investing in dozens of companies per cohort, but not great for angel investors who want to do more than hand over a check and pray.
For the startup founder, no investor oversight may seem like heaven. All I can say to that is that if you want to go it alone, that’s fine, but if you don’t want me to be part of the company, don’t ask for my investment.
Convertible notes have a maturity date by which time the note has to be converted to equity. This sets a deadline for getting the Series A funding round completed. For tax reasons, the investor will demand the maturity be as soon as possible, typically 18–24 months.
Further, convertible notes can specify some detail of what must be included in the preferred shares on conversion.
For these two reasons, most investors prefer convertible notes over SAFEs, while some prefer the possible tax benefits of SAFEs.
Which One to Choose?
Typically, friends and family rounds are SAFEs, pre-seed and seed rounds are convertible notes, and series A (by definition) is preferred equity. However, more and more frequently, I’m seeing pre-seed and seed rounds also being raised on SAFEs.
If you’re opening a substantial round and expecting large venture capital funds to write big checks, you won’t have a choice. They’ll require preferred shares and will have many demands on the term sheet. Time to hire good lawyers.
In the early friends and family round, SAFE is a good choice. It’s simple for both parties. You can change the valuation cap as the company makes progress without having to set up a new funding round.
Pre-seed and Seed rounds are where the trade-offs have to be weighed.
Preferred equity will take time and money to negotiate, and will likely include a board seat and other investor protections. While the hassle factor is higher, this makes the investment more attractive to investors. You may be able to attract more investors with preferred shares or negotiate a higher valuation.
The convertible note is simpler and faster than equity and looks more professional than SAFEs. Convertible notes are acceptable to all angel investors. However, for the startup, it sets a deadline for completing Series A which can cause problems later.
SAFEs are simpler and faster than convertible notes and may offer tax benefits immediately. However, SAFEs contain no investor protections and no deadline for getting the real stock documents with investor protections. In addition, there is still a stigma associated with SAFEs due to the earlier pre-money version.
Consequently, some early-stage investors prefer convertible notes and some prefer SAFEs. Personally, if I’m investing on my own, I prefer the simplicity of the SAFE. If I’m investing as part of an angel group, the ability of the group to negotiate conditions in the convertible note makes it preferable if equity is not an option.
For the founder, whether to choose preferred equity, convertible note, or SAFE depends on the size of the round, confidence in raising the next round quickly, and the preference of potential investors. Make sure to choose wisely.
If you found this article helpful, please leave a note in the comments. Hearing my article has been useful is so much more valuable to me than the tiny amount Medium pays. If I got anything wrong, corrections are appreciated, too.
Disclaimer: If it isn’t clear from the way I write, I’m not a lawyer. A lawyer’s job is to warn you of every possible risk. My job is to boil down the complexity to the stuff most people need to know. That may or may not cover the particulars of your situation. In addition, I’ve spent my career building startups rather than studying tax law, so some of this might be wrong. If so, I promise to return all 3 cents that I earned for writing this article (minus the $30 wire fee). Sorry, that’s the only guarantee you get. As always, do your own diligence. As a founder (or investor) you are solely responsible for your own fate.
A big thank you to master negotiator Doug Swets for sharing his incredible expertise in startup financing to help me write this article.