Is a SAFE a Convertible Note? Key Differences Explained

Early-stage companies often seek capital to develop their operations and pursue growth. Before a definitive company valuation can be established, non-equity investment instruments provide a flexible way to secure initial funding. Two common tools utilized for this purpose are the convertible note and the Simple Agreement for Future Equity (SAFE). Both instruments allow investors to provide capital with the expectation of receiving equity in the company at a later date. They serve to bridge the gap between initial funding needs and a formal equity financing round.

Convertible Notes Explained

A convertible note is a debt instrument provided by an investor to a company. It is a short-term loan that allows conversion of the loan amount into equity at a future point. This debt is recorded as a liability on the company’s balance sheet until the conversion event occurs.

Convertible notes include a maturity date, which is the deadline by which the loan must either be repaid or converted into equity. This date typically ranges from 18 to 36 months after the note’s issuance. If the company does not raise a qualified financing round before this date, the note may become due and payable, requiring the company to repay the principal and any accrued interest.

These notes carry an interest rate, which accrues on the principal amount over the term of the loan. This interest is usually not paid out in cash but is added to the principal amount and converts into equity alongside it.

Conversion of the note into equity is commonly triggered by a qualified equity financing round. During this event, the investor’s loan, including accrued interest, transforms into shares of the company. To incentivize early investment, convertible notes frequently include a valuation cap. This cap sets a maximum company valuation at which the note will convert, ensuring the investor receives shares based on a lower, predetermined valuation even if the company’s value increases significantly.

Another feature often included is a discount rate. This allows the investor to convert their investment at a lower effective price per share compared to new investors participating in the future equity round. These features reward early investors for the increased risk they undertake by providing capital before a company’s valuation is firmly established.

SAFEs Explained

A Simple Agreement for Future Equity (SAFE) is a financial instrument that grants the right to receive equity in a company at a future date. Unlike a convertible note, a SAFE is not considered a debt instrument. It represents an agreement for future equity, meaning it does not create a loan obligation that must be repaid.

SAFEs do not have a maturity date. The agreement remains outstanding indefinitely until a predefined conversion event occurs. This structure eliminates the pressure on companies to repay or extend the agreement by a specific deadline, providing greater flexibility.

SAFEs do not accrue interest. This contrasts with debt instruments that typically require interest payments or accruals. The lack of interest simplifies the financial terms for both the company and the investor.

Conversion of a SAFE into equity is generally triggered by a qualified equity financing round. Upon such an event, the investor’s original investment converts into shares based on the terms outlined in the SAFE. Other events, like a company sale or initial public offering, can also trigger conversion.

SAFEs commonly incorporate a valuation cap. This cap sets a maximum valuation for the company at which the SAFE will convert, offering early investors protection against excessive valuation increases. If the company’s valuation in the subsequent equity round exceeds the cap, the SAFE converts at the capped valuation, resulting in more shares for the investor.

A discount rate is another frequent component of SAFEs. This provision allows the investor to convert their investment at a reduced price per share compared to the price paid by new investors in the future financing round.

Distinguishing Features

A primary difference between these instruments is their legal nature. A convertible note is classified as a debt instrument on a company’s balance sheet. This means it carries the legal characteristics of a loan, including potential repayment obligations and creditor rights for the investor. In the event of company liquidation, convertible note holders typically rank as creditors, ahead of equity holders, for recovery of their investment.

A SAFE is not debt; it is an agreement for future equity. It does not appear as a liability on the balance sheet in the same way a convertible note does, which can simplify financial reporting for the issuing company. Since SAFEs are not loans, they do not provide investors with the same creditor protections or liquidation preferences that a debt instrument would.

The presence or absence of interest and a maturity date creates further distinctions. Convertible notes include both an interest rate, which accrues over time, and a fixed maturity date. The maturity date imposes a deadline on the company, potentially forcing repayment or renegotiation if a conversion event does not occur.

SAFEs do not accrue interest and do not have a maturity date. This eliminates the financial burden of interest calculation and reporting for the company. The absence of a maturity date removes the pressure of a looming repayment deadline, offering founders more time to achieve milestones before a priced equity round.

The two instruments also differ in their perceived complexity and standardization. Convertible notes can involve more customized terms and legal documentation due to their debt characteristics. While standard templates exist, negotiations can lead to variations that require more legal oversight. SAFEs are largely standardized with fewer negotiable terms. This standardization contributes to their perceived simplicity and can lead to lower legal costs and faster fundraising processes.