Early stage investing trends: SAFEs versus convertible debt

September 2016 | SPOTLIGHT | FINANCE & INVESTMENT

Financier Worldwide Magazine

There’s a new sheriff in town. Over the past 18 months, many start-ups and early stage companies needing a quick cash infusion have discovered a popular new device – the Simple Agreement for Future Equity (SAFE). The good old days of friends, family and angels investing early stage capital in exchange for common stock are long gone. In its place arose a wave of convertible debt and seed preferred stock as popular vehicles for raising capital prior to a more sophisticated (and negotiated) preferred equity round.

For those investors and companies looking for a simple and quick cash infusion without having to agree upon a valuation or pay lawyers material sums, today’s choice of instruments is increasingly between a convertible promissory note or a SAFE. In this regard, the key similarities and differences between these two investment devices should be reviewed.

Convertible promissory notes

When early stage companies in the pre-revenue stage succeed in accessing a modest amount of short-term cash, it is often premature to spend the time and resources negotiating the detailed terms of a preferred equity round. Further, using convertible debt rather than equity permits the issuer to avoid debating a precise valuation with its investors. The parties often find it much easier to agree upon a mid-point valuation ‘cap’ to protect investors’ conversion upsides in exchange for their early risk taking instead of exactly pricing a round.

As convertible debt is truly debt, the investors are ahead of equity holders in the event a liquidation event occurs before the debt converts to equity. In other words, in a downside scenario prior to an equity financing in which the issuer needs to dissolve and liquidate its assets or sell its business, the note holders will receive their principal and accrued interest ahead of the founders and other stockholders. Further, the notes will be ‘pari passu’ with all other unsecured creditors, as it is very rare for these notes to be secured.

The principal and accrued interest under a convertible promissory note will automatically convert into substantially the same equity issued in a ‘qualified’ equity financing, typically defined as the issuer’s next equity financing receiving an agreed minimum amount of capital. If the issuer first consummates an equity financing below such a threshold, the note holders (often controlled by the holders of a majority of the aggregate principal amount of such notes) will instead have an option to convert their principal and accrued interest amounts into substantially the same equity offered in such non-qualified financing. In either event, the ‘conversion price’ for the notes will be the lesser of an agreed discount (10 percent to 20 percent) against the applicable offering price or the value of a share of the issuer’s fully diluted (as converted) common stock based upon the valuation cap.

If, prior to conversion and the note’s maturity date, the issuer consummates a ‘liquidity event’, such as the sale of the business or change of control transaction, note holders may have an option to convert into equity at the valuation cap (effective immediately prior to the transaction) or elect to be fully repaid, often at a premium ranging up to two times the principal balance.

Lastly, if the note simply reaches maturity prior to any of the stipulated events, it would be due and payable, providing the holders with leverage if the issuer requires an extension. Some notes may also provide for mandatory or optional conversion upon maturity (at the valuation cap).

Unless specific covenants are included in the debt financing documents, the note holders will have no influence or control over management decisions and will not be entitled to dividends alongside the issuer’s stockholders (though early stage dividends are unlikely).

SAFEs

The SAFE is legally a contract of the issuer, constituting an agreement to issue equity in the future at a purchase price paid in advance. It is not debt and, unlike a convertible promissory note, accrues no interest and has no maturity date. However, in a downside scenario, like holders of unsecured debt, a holder of a SAFE is an unsecured creditor with status subordinate to any secured debt but senior to equity holders.

It should be noted that SAFEs may have a discount with no valuation cap, a valuation cap with no discount, both a discount and a valuation cap or simply a ‘most favoured nation’ right.

Similar to convertible notes, using a SAFE allows the parties to avoid the full valuation negotiation, instead using a mid-point valuation cap or excluding a valuation cap altogether. A SAFE automatically converts into substantially the same equity issued in a ‘qualified’ equity financing, defined in a similar manner as it is in convertible notes (though often with no minimum investment threshold). As with convertible notes, the ‘conversion price’ for SAFEs will be the lesser of the stipulated discount (10 percent to 20 percent) against the applicable offering price or, if the SAFE includes a valuation cap, the value of a share of the issuer’s common stock calculated based upon the valuation cap.

If, prior to a qualified financing, the issuer consummates a ‘liquidity event’ (initial public offering, sale of the business or other change of control transaction), holders of SAFEs typically have an option to convert into common equity at the valuation cap (effective immediately prior to the transaction) or to be repaid their purchase price. In the event of insufficient funds, this repayment right will be senior to any dividend rights of the stockholders.

Holders of SAFEs, like holders of notes, will have no voting or dividend rights.

Another common feature of SAFEs is the inclusion of an issuer covenant to provide limited pre-emptive rights after the qualified financing, providing holders the opportunity to maintain their expected ownership level after that point in time. This provision may be resisted by savvy issuers, though, as providing such a benefit without having yet negotiated the terms of the preferred equity may hinder the issuer’s ability to limit such rights to ‘major investors’.

Key differences between convertible notes and SAFEs

While convertible promissory notes and SAFEs share many traits, as previously noted, there are some key differences. First, notes include a maturity date; barring a conversion event, the loan will become due on a set date and note holders will have leverage over the issuer if asked to extend or amend the terms of the debt. Second, SAFEs do not accrue interest like notes, providing a material benefit to founders and the issuer’s balance sheet. Third, SAFEs are contracts and, as such, are typically issued without a separate subscription agreement, while notes are often issued pursuant to a note purchase agreement. One fewer document to negotiate means less time and cost for the issuer. Fourth, SAFEs typically include limited preemptive rights. Though notes may include a similar covenant, they do so less often. Fifth, convertible notes provide optional conversion for a non-qualified financing, while the standard SAFE does not, maintaining the status quo until a qualified financing or a liquidity event. Finally, as a debt instrument, notes may trigger certain state finance regulations.

Conclusion

Early stage companies must understand the landscape in structuring their financing rounds. Both convertible promissory notes and SAFEs are investment devices giving companies and investors a quicker and less expensive path to closing.

Though SAFEs resemble notes in several ways, issuers and investors should be sure they can decipher the key differences between the two instruments. With a full understanding of the respective traits of these devices, issuers and investors can better navigate the landscape of early stage financing, matching their needs and concerns with the appropriate structure.

Michael Gray and Joshua Klein are partners at Neal, Gerber & Eisenberg LLP. Mr Gray can be contacted on +1 (312) 269 8086 or by email: mgray@ngelaw.com. Mr Klein can be contacted on +1 (312) 269 8438 or by email: jklein@ngelaw.com.

Michael Gray and Joshua Klein

Neal, Gerber & Eisenberg LLP