Convertible Notes, SAFEs and Liquidation

Convertible Notes, also known as convertible promissory notes, bridge notes, or convertible debt (“Notes”) and Simple Agreements for Future Equity (“SAFE”) are both methods of start-up financing that convert into equity at predetermined conditions in a future financing round. However, while they share some similarities, entrepreneurs and investors should consider which options are more preferable to them.  

In our previous post, we have discussed about the charachteristics of Note and SAFEs (Read here Karm - post (karmadv.com)). In this post, we talk about the liquidation preference and pros and cons of the Notes and SAFEs. 

Liquidation Preference

Liquidation preference is an important term to investors as it determines what the investor will be paid and their priority in the event of liquidation. There are two types of liquidation preference; participating and non-participating and both methods give investors the choice to convert their shares into common shares. Non-participating liquidation preference prioritises preferred shares over common shares at aprice equal to what they paid per share or a multiple of the share price, depending on the terms of the agreement.  If the investor does not convert his shares, then the investor will be paid the investment amount plus any interest before common shareholders. If they do convert their shares, then they will be paid the investment amount first with interest and then share in any gains made by the liquidity event on a pro rata basis. Participating liquidation preferences are the same as a non-participating preference except that if the investor holding preference shares chooses to convert, the investor will be paid the investment amount plus interest first and then a pro rata share of the common shares prior to any other distributions of the remaining shareholders. 

Additionally, Notes will usually also contain the following terms and conditions; a valuation cap, which sets the maximum valuation at the time the note converts, a discount rate for investing early, an interest rate paid back in equity and a maturity date by which company must repay the debt. SAFEs are very similar to Notes with most aspects such as the valuation cap, discount rate remaining the same. However, SAFEs do not have a maturity date or interest and is therefore not a loan. This key difference usually makes SAFEs more preferable to Notes for start-ups.

Pros and Cons of SAFEs and Notes

Notes are a debt on the company that matures with interest and therefore it is a debt that the company will have to pay back at some point in the future. Furthermore, a debt on the company will have a higher priority in the event of liquidity and could even trigger insolvency should an investor demand their investment back. Comparatively SAFEs are not debt and do not have a maturity date Therefore companies do not have to fear the investment and interest becoming due and payable. SAFEs also provide better protection of the company’s equity in the event the SAFE never matures. On the other hand, if the SAFE never matures, the obligations placed on the company under a SAFE can potentially remain indefinitely. Nevertheless, both options usually include valuation caps and discount rates in order to make it attractive to early investors.  This may hinder future financing rounds if done without proper forethought.

On the other hand, start-ups and seed investors often choose to use Notes and SAFEs because these two options are fast, simple and cost effective in comparison to traditional seed financing. The agreements themselves can be fairly simple and straightforward in regards to the terms and conditions of the conversion of investment into equity. This also reduces the time and legal fees required in preparing the agreement, while providing transparency, with both parties clearly understanding what they are receiving. Most importantly, Notes or SAFEs offer high resolution fundraising whereby the parties gain their respective benefits as soon as the parties are ready to execute the agreement.

 

 

Authored by Bryce Mendonca (Associate). 

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