Convertible Notes & SAFEs
A convertible note is a type of financing for companies. Notes are structured as debt with the ability to convert into equity based on the achievement of certain milestones. Convertible notes have become one way early stage companies choose to raise money from investors. You may have heard about SAFEs or SAFE notes. The SAFE or Simple Agreement for Future Equity is a type of convertible note, which Y Combinator introduced in 2013. In this article, we will cover what is in a convertible note as well as some of the controversy around notes.
There are a few terms to pay attention to in any convertible note, often referred to as a note:
- Capital invested (“the balance” or “the principal”) – The amount invested in the convertible note.
- Conversion price – The per share price where notes convert. If a company raises a $2 million convertible note, the conversion price tells everyone how many shares that $2 million investment becomes in the company when it converts to equity. The conversion price will depend on the conversion discount and valuation cap discussed below.
- Conversion discount (“the discount”) – The percentage discount gained by the convertible note investors in the next financing. For instance, a note may convert at a 15% discount to the conversion price in the next financing round, so if a company raises equity financing at $10 price per share, the note converts at a $8.50 price per share.
- Valuation cap (“the cap”) – Convertible note investors do not want to have a situation where they invest early in a company’s life and then convert at a discount years later when the company may be worth hundreds of millions of dollars. A $2M note investment converting at a 15% discount to a billion dollar valuation yields quite a small ownership percentage. To protect themselves from this, there can be a cap on convertible notes. The cap sets a maximum conversion price on the note. If a note has a discount (e.g. 15% of the price of the next round) and a cap (e.g. a $20 million valuation cap), the noteholder will convert at the lower of the two conversion prices.
- Interest rate – The annual interest rate accrued on the principal invested via the convertible note. If there is a $2 million convertible note with an 8% annual interest rate, the principal grows by $160,000 (8% of $2 million) in year one. Like some equity investments, interest rates are accrued and added to the balance of the investment instead of paid out as cash.
- Conversion provisions – These are the circumstances that outline when a convertible note converts into equity. This may be the earlier of a finite date in the future (“the maturity date”) or a qualified financing (an amount of financing above a certain amount) such as a Series A/B/C or an IPO. There may also be certain provisions in a convertible note that allow a company to pay off the note without penalty to prevent the investors from converting into equity.
- Maturity date – A date in the future which outlines when investors can call (“ask for”) the convertible note to be repaid in cash. For early stage companies, maturity dates may be 18 to 24 months following the note, and in practical cases, investors will likely tend to extend the maturity date as opposed to call payment then because it could put the company out of business. In some situations, the maturity date may also set the date in which the convertible note automatically converts into equity and at what conversion price.
- Warrant coverage – Some convertible notes may have what’s known as warrant coverage, which is the option to purchase additional shares when the note converts into equity. Warrant coverage will likely be structured as a percentage of the amount raised in the note. For instance, a $500,000 note (assuming no accrued interest and no valuation cap) with 8% warrant coverage would give investors the opportunity to purchase $40,000 worth of shares at the price of the next round.
If you are considering a convertible note, you may go through a typical fundraising process. Founders or investors may draft and execute a convertible note term sheet, which becomes a convertible note purchase agreement when agreed upon by all parties and finally is cemented with the convertible note certificate.
The SAFE Note
The SAFE, or Simple Agreement for Future Equity, is a form of financing created by Y Combinator, which is similar to a convertible note with a few key differences. First, interest does not accrue. Second, there is no maturity date. Y Combinator offers four free SAFE templates depending on if you want to set a valuation cap (on the post money of your next round, a discount, or include a Most Favored Nation (MFN) provision.The MFN provision comes into play if there are multiple SAFEs, and an investor wants to use the terms of a different SAFE. The MFN may apply in cases where a company raises multiple SAFEs, one after the other, before their next priced equity round. All in all, SAFEs are a simple document with only a few inputs.
One argument for convertible notes at the early stage of a company's life is that it makes the fundraising process simpler and avoids a price round -- that is, a financing event which sets a valuation on the company. It can also be cheaper and administratively easier.
With the economic turbulence in March 2020 due to COVID-19, folks have raised a flag about the consequences of convertible notes, which many failed to consider. One of the key concerns is that while convertible notes have a capped conversion price on the upside, they do not have a capped conversion price on the downside. For reasons completely unrelated to your company, general valuations can contract, and the consequences of converting that note into equity may cause more dilution than you expected. Our favorite article on this topic comes from this Forbes piece.
It helps to think about three groups when considering a convertible note. First, there are the existing shareholders, which may include founders, early employees, and other investors such as friends and family. Second, there is the group of investors who will invest through this note. Third, there are the group of investors who plan to invest in the round of financing after the note. If this note is your last planned round of financing before an exit, then you can remove the third group. Some companies raise one convertible note and never raise again. For more on that, you can read about the situation at Toptal. Whether you approve or disapprove of convertible notes, it is important to consider future scenarios when evaluating any form of financing. This can be as simple as having a discussion about what happens if the company declines in value or grows in value and can be as complex as building out a full table of proceeds at various exit valuations.
The Multiple Liquidation Preference Problem
There have been cases in the past where convertible noteholders accidentally accrue multiple liquidation preferences. This is something to watch out for as it can harm existing shareholders and scare away future investors. This can happen when a company raises a traditional convertible note with the intention of converting into equity in the next priced round. Simple stuff: you raise a note from seed investors at a cap of $10 million who will convert when you raise the Series A. If you raise a $10 million Series A at a $40 million pre-money valuation with a straight 1x liquidation preference, your noteholders will convert into equity and get Series A preferred stock. But their stock now has a 1x liquidation preference and they converted a conversion price set at the $10 million cap. Uh-oh. Now you have a 1x liquidation preference at a price 4x greater than the conversion price. Your convertible noteholders may now have a 4x liquidation preference. This will probably not materialize, and your Series A investors will want to negotiate this away. It could, however, delay the cash infusion.
Startups may opt to include a provision in their convertible note agreement allowing a “majority in principal amount of the notes then outstanding” to waive or veto any particular provision in convertible note agreement. Or you can add a different phrase recommended by this lawyer to the note, “regardless of the cap and the discount, in no event shall the noteholders be entitled to a liquidation preference of greater than 1x the money they invested in the notes.” With potential edge cases like these, some companies are encouraged to do a priced round versus raising a convertible note.
1. Does a convertible note convert into common or preferred stock?
You may be wondering, "does a convertible note convert into preferred stock or common stock?" This depends on the terms of your convertible note agreement. In some cases, the principal of your note will convert into the preferred stock of the next round, while the accrued interest may convert into common stock. In other cases, principal and accrued interest may convert into preferred. This is to be negotiated.
2. What happens if a company is acquired before the note converts into equity?
This can happen from time to time. Investors may invest via a convertible note early on in the company’s life, and a large tech company may swoop in to acquire the business early on. What happens in this case will be spelled out in the convertible note agreement with the Early Exit Payback provision. There are a few variations to what happens during an acquisition or merger. You may see the notes convert into common stock immediately before the acquisition. In other cases, the noteholders may get preferential treatment before the shareholders, receiving a multiple on their invested capital and accrued interest. Finally, you may see a situation where the convertible noteholder can choose between receiving a set multiple on their invested capital (e.g. 2x) or converting into common stock at a set conversion price.
3. What happens with multiple tranches of debt?
If you have other forms of debt such as a line of credit or long term bank debt and you choose to raise a convertible note, then you will need to obtain an intercreditor agreement. This will iron out the debt hierarchy (i.e. who gets paid first) and represent the consent of your other lenders to raise the note.