There are three accepted vehicles to document raising money from family and friends in the early stages of a company’s life: (1) a convertible promissory note; (2) the Founders Institute Plain Preferred Term Sheet; or (3) the Y Combinator's SAFE document.
In California, many early stage corporations prefer using the SAFE document. Elsewhere in other states, corporations might prefer the more traditional convertible note.
Here at Smith Shapourian Mignano PC, our clients often inquire as to whether to raise money at the pre-seed or seed stage via a convertible note or a SAFE document. To that end, we provide this brief blog article to inform early stage entrepreneurs about the differences between the two.
Convertible Promissory Note
Convertible notes are term or demand promissory notes that convert into a start-up’s equity. Convertible debt financings have increasingly been used to fund very early-stage startup companies who are raising money from family and friends.
An event (such as a new series of preferred stock, change of control, etc.) triggers the note holder's right to exchange the debt for a specified class of the start-up’s stock. Convertible notes provide investors an opportunity to table the decision as to whether they wish to invest in the start-up’s equity, given the degree of progress the start-up achieves to reaching its business goals.
There are reasons for opting to document the transaction by way of a convertible debt financing document.
First, it is often very difficult to value early-stage start-ups. A convertible note allows the start-up and the investors to defer valuation until one is determined during an equity financing.
Second, the outstanding debt of a convertible note will likely convert into preferred stock in the next round of equity financing.
Third, investors use the debt features as a way to justify the investment, and employ a risk versus benefit analysis to decide upon the required terms of the transaction. In so doing, they may benefit from the potential equity kicker of the convertibility feature.
Finally, the investors in such transactions are not stockholders, and so they are not technically not part of the capitalization table of the start-up. Such investors generally do not have any voting rights and cannot impede the founders from making business decisions.
In general, the more modern SAFE document is intended to replace convertible notes. The creator of this document, Y-Combinator, believes that the SAFE addresses many of the problems with convertible notes while preserving the convertible notes’ flexibility aspect. They’ve also expressed the view that the SAFE improves fairness between investors and founders.
Unlike a convertible note, the SAFE is not a debt instrument. It does not have a maturity date, and it may not be subject to regulation in the same manner as convertible notes under Federal and state securities laws. A SAFE cannot give rise to the specter of insolvency in struggling start-ups. It lacks security interests and subordination agreements, all of which things can have unintended negative consequences for start-ups.
Second, since it’s not a loan, it does not accrue interest.
Third, since a SAFE deal is entirely evidenced by a single document (without numerous terms needing to be negotiated), SAFEs can save start-ups time and money. Negotiation between a start-up and its investors will be reduced to the existence and amount of a valuation cap and the discount, if any, with respect to the purchase of a subsequent Series A Preferred round. Since the SAFE does not have an expiration or maturity date, there is no need to renegotiate the original deal in order to extend maturity dates, revise the interest rate, or similar items later on down the line.
Finally, unlike more traditional equity financings, using a SAFE allows the start-up and a single individual investor to complete the transaction as soon they want. It is an efficient process; there’s no need to coordinate a single, simultaneous close with all investors at the same time.
There are four versions of Y-Combinator’s SAFE, corresponding, according to Y-Combinator, to the four types of convertible notes, including:
• SAFE: Cap, no Discount
• SAFE: Discount, no Cap
• SAFE: Cap and Discount
• SAFE: MFN, no Cap, no Discount
Smith Shapourian & Mignano, PC is available to answer any questions or concerns you may have regarding raising money from family and friends in the early stages of a company’s life.
This blog does not constitute solicitation or provision of legal advice, and does not establish an attorney-client relationship. This blog should not be used as a substitute for obtaining legal advice from an attorney licensed or authorized to practice in your jurisdiction. You should always consult a suitably qualified attorney regarding any specific legal problem or matter in a timely manner, as statutes of limitations may bar your claim.