Tl;dr: Do you understand the difference between a SAFE and convertible note? If not, we are going to break down the key things you need to know so you won’t be taken advantage of. In short, SAFE is not as great as you think.
So you have read about convertible notes, and depending on where you live, SAFEs (They’re only really popular in the Bay Area). So what is the difference? Well, we’re going to get into the differences to a relatively technical level (but not too nerdy).
The goal of this blog is not to teach you everything about convertible notes and SAFEs and do primers on all the terms (though I am going to cover the basics to some extent, as usual). I’m going to focus on the differences. For everything you don’t understand you need to read up. Yes, I know that’s a pain, but if you keep learning you will eventually know a lot. I know as I taught myself, so I am proof! Hopefully positive proof 😉
Download the SAFE vs. convertible note matrix
What is a SAFE note?
SAFE is an acronym that stands for “simple agreement for future equity”. It was created by the Silicon Valley accelerator Y-Combinator as a new financial instrument to simplify seed investment in 2013. It aims to be a short and simple document. The new Post SAFE docs range from 5-7 pages (Including the signature page).
You sign them with investors when you are raising and the investor gives you money. The investor then gets shares in the future when they convert at your series-a.
At its core, a SAFE is basically a warrant to purchase stock in a future priced round. SAFEs are more like equity instruments than debt, so they rank after convertible notes in a liquidation. Meaning if your company fails, then the investors get money back pretty much last, after convertible notes (if any were issued).
In the words of Carolynn Levy, the YC partner and former Wilson Sonsini lawyer who created the SAFE
“[t]he Safe is just a convertible note with the ‘event of default,’ interest, and maturity date provisions stripped out. It is a convertible security with a creative acronym.”
There are many similarities between SAFE and convertible notes investments.
- They are used to bridge to a real funding milestone like a seed round (before seed became a phase) or a Series A.
- They are both viewed as being faster and cheaper to execute than a full priced round by most people.
- They also can have the same types of terms such as a discount, cap, MFN (most favored nation), convert predominantly into the same class of share as the next round as well as pro-rata rights (as agreed. The new SAFE only has pro-rata as a side letter. Press to download).
- The SAFE has fewer terms than a convertible note, and the convertible note is normally longer (and there are two documents).
The new and old note
Yup, things are going to get a little complicated for those who haven’t been paying attention. There is an old and new SAFE structure.
The new post money note was introduced as the standard in October 2018.
- The old one is a pre-money note
- The new one is a post-money note
So why the change? Well, when Y-com introduced the note, startups and investors were primarily using convertible notes for early stage fundraising. The original safe was intended to be a replacement for convertible notes.
The world has changed though. Seed funding is now a phase, not a funding event. The way early-stage companies raise money from investors has changed and so is the way they used the old SAFE. People used the old SAFE as a bridge to priced preferred stock rounds. Now multiple seed rounds can provide multi-year runways with no conversion to shares.
So, four years after introducing it, they decided to change it, ostensibly for that reason but championed with the promise of ‘clarity’ of who will own what.
There are two main changes I will touch on. I’ll write a blog on the difference between the old and new SAFE to get into more detail:
Post-money instead of pre-money
The most significant change in the new SAFE is that it is now a post-money convertible security instead of a pre-money one. This means that ownership of a SAFE investor will be measured after (post) all funds raised from SAFE notes (whether in one or multiple signed over a period of time) but before (pre) new capital raised from equity investors (and increase in ESOP) in a priced round in which the SAFEs are converted into equity. The SAFE is effectively a standalone round.
Removed pro rata right
They removed the pro rata right as a default, which was a default in the original safe. That pro rata right in the old SAFE applied to the financing after the round in which the original safe converted (e.g. if the original safe converted in the Series A, the pro rata right applied to the Series B).
This didn’t make sense for two reasons:
- Standard pro rata rights don’t make sense for both angels and institutional investors. A startup raising $500k from 10 angels ($50k each) has different considerations than raising $2m from a single institutional investor
- Founders and investors got confused as to which round the pro rata applied. They thought it applied when the SAFE converted (the Series A), rather than the round after conversion (the Series B).
There is now an optional and standard side letter with pro-rata rights that apply to the round in which the safe converts (e.g. if the safe converts in the Series A, the pro rata right applies to the Series A).
Four versions of the new note
There are four versions of the new post-money safe, plus an optional side letter. The titles are pretty self-explanatory. You can download the docs from each of these links:
- Safe: Valuation Cap, no Discount
- Safe: Discount, no Valuation Cap
- Safe: Valuation Cap and Discount
- Safe: MFN, no Valuation Cap, no Discount
- Pro Rata Side Letter
If you want the plain English guide to the notes, I’ve done a line by line of each of the documents here so you understand everything that is in them:
- Safe: Valuation Cap, no Discount
- Safe: Discount, no Valuation Cap
- Safe: Valuation Cap and Discount
- Safe: MFN, no Valuation Cap, no Discount
- Pro Rata Side Letter
What is a convertible note?
A convertible note is a type of debt that has the right to convert into equity when you hit an agreed upon milestone. It’s structured similarly to an unsecured loan. This debt automatically converts into shares of preferred stock upon the closing of a qualified financing round, such as a normal priced seed or Series A round of financing. The thing with convertible notes is that the more you know, the more you realize that they are complex and have the potential to be misunderstood.
As we discussed, they are very similar to a SAFE. The difference being that they have a maturity date (deadline), they are longer, and there is an interest rate (which makes them debt). We’re going to go through the differences in a minute.
SAFE vs. convertible note matrix
To make it easier to compare the SAFE (New one) and convertible notes, I’ve put together a matrix. You can download this for your nerdy pleasure in the download box at the top.
|Variable||SAFE||Convertible Note||What’s better for a founder|
|Structure meaning||Investors pays money to have the right to get equity at a conversion event||Investor loans money which can convert to equity at a qualifying fundraising round||n/a|
|Speed||Highest (Less terms)||Lowest (more terms)||SAFE|
|Complexity||Lowest||Highest||CN if you want control|
|Document length||Shorter||Longer||CN if you want control|
|Number of documents||1||2||Doesn’t matter|
|Best for||Inexperienced||Master||Better to be master|
|Wolfenstein game play||Can I play, Daddy?||I am death incarnate!||Better to be master|
|Interest rate||No||Yes (2-8%, average 5%)||SAFE|
|Valuation cap||Yes (Unless you are hot)||Yes (Unless you are hot)||Either|
|Valuation discount||Yes (Rarely no discount)||Yes (Rarely no discount)||Either|
|Maturity date (When converts)||None||Yes (Typically 18-24 months)||CN (Less obvious reasons)|
|What happens at maturity||There is no maturity||Three options at maturity:
1/ Pay back principle + interest
2/ Convert to equity shares
3/ You negotiate (Reality is not binary)
|Cost||Free (There is very little to change)||Higher (Can get complicated if you understand CNs)||SAFE|
|Pro-rata||As agreed as a side letter (Template only for cap version)||As agreed||Either|
|Conversion trigger at financing||Whenever you issue preferred shares with often no threshold.||Typically at an investment threshold||CN|
|Conversion if you sell common shares||No (You can do a friends and family round if you are running out of cash)||Yes, if exceed investment threshold (Can depend)||CN|
|Conversion if you sell preferred shares||Yes||Yes||Either|
|Conversion trigger threshold||Not defined||Defined (Normally)||CN|
|Liquidation preference overhang||No||Both (Depends if you add clause)||Either (If CN written properly)|
|Most favoured nation||Yes (If included)||Yes (If included)||Either|
|Early exit||Possible to include a payout in case of change of control: 1x payout or conversion into shares||Possible to include a payout in case of change of control (Sometimes 2x payout, e.g. for 500 Startups)||Typically the same|
|Exit order||SAFE rank after Notes||Notes rank over SAFE||Doesn’t matter to founder|
|Dilution at new rounds||SAFE do not dilute one another||CNs dilute one another||CN|
What’s the same about SAFE and a convertible note?
We know there are a lot of similarities. So let’s get into them in a little detail.
A cap sets the max price that investors pay. It is not the floor! It’s the maximum amount that the investor will pay for preferred shares when you raise your series-a, regardless of what the price per share is calculated as when valued.
Depending on your negotiating skills and your company’s traction, you can get a SAFE or convertible note without a valuation cap. It’s called an uncapped note. However, it’s pretty hard to negotiate for!
If you have a low cap, then you can get diluted more than you probably thought you would be under a convertible note and the old SAFE. Andrew Krowne of Dolby Family Ventures wrote in TechCrunch:
“We have observed that many founders don’t do the basic dilution math associated with what happens to their cap table (specifically their personal ownership stakes) when these notes actually convert into equity. By kicking the valuation can down the road, often multiple times, entrepreneurs end up owning less of their company’s equity than they thought they did. And when an equity round is inevitably priced, entrepreneurs don’t like the founder dilution numbers at all.”
When you set a cap you are effectively setting a valuation, in a round where you didn’t think you were negotiating a price at all.
The discount is simple. It’s just a number less than what the price the series-A investor pays. So if you have a 20% discount to what the investors pay: Series-A price x (1-20%). So if price is 5, it’s 5 x (1-20%) = 4.
Note the 1-20% bit. This is really important. When you write your docs it’s 80 NOT 20! I have a friend that thought doing his own convertible note was a good idea and issued a note with an 80% discount. He didn’t get the 1- bit.
The 1- % is termed as the Discount Rate in the SAFE docs (The “Discount Rate” is [100 minus the discount]%.).
If you have both a discount and a cap the investor takes the number which gives them a lower price per share.
You don’t have to have a discount on either, but they are pretty normal. If you don’t have a cap, you 100% have a discount in your agreement. Otherwise, the investor should have just invested at the round in which they convert. The alternative is a document with an MFN or Most Favoured Nation clause, which means investors get the same terms as new convertible note holders. That rarely makes sense and only if you intend writing more SAFEs before you do the series-A.
If you want to understand how all the math works, you can download a SAFE calculator I made here: SAFE Calculator for the Y-Combinator Post Money SAFE.
Early exit clause
If you have an early exit, convertible notes and SAFE have similar payout mechanisms in the event of a change in control (acquisition/IPO). The SAFE is written to give the investor the choice of a 1x payout or conversion into equity on an “as converted basis”. The convertible note may vary, but will typically be similar.
The SAFE describes it as:
In a Liquidity Event, a safe holder is entitled to receive a portion of the proceeds equal to the greater of (1) a return of its Purchase Amount and (2) the as-converted proceeds it is entitled to in connection with a Liquidity Event (i.e., the proceeds it would be entitled to had its Purchase Amount been converted into common stock at the Post-Money Valuation Cap). In a Liquidity Event, the safe is junior to creditors and outstanding indebtedness (including outstanding convertible notes) and has the same priority as standard non-participating Preferred Stock.
Conversion into the same class of shares as the next financing round
Assuming both converts at a ‘normal’ round where preference shares are being issued, then both SAFE and the Convertible Note get preference shares (normally) and the same terms as the investors.
One little difference is the SAFE may convert (depends on which SAFE document you use) into a class of stock called SAFE Preferred Stock. SAFE Preferred Stock has the same “rights, privileges, preferences and obligations” as Standard Preferred Stock, but the liquidation preference, conversion price, and dividend rate are calculated based on the price per share of the Safe Preferred Stock. This effectively prevents a liquidation overhang.
Read more here: Convertible note terms that you don’t understand
In both cases, the SAFE and note will convert into equity. Both investors don’t know what the exact terms of the shares will be. That will be set by the lead investor in the round. One slight difference is with the post money note where the investor knows (mainly) how much they will own before the round, when they get diluted by the ESOP increase and the series-a investment. It’s not as clear for convertible notes which dilute one another (Post SAFE don’t dilute one another).
You know what. People give reasons for why terms aren’t set when people do notes, but my no-BS logic for why you don’t set terms, is who cares? You need to get shite done and product shipped, and frankly you’re not really worth enough for anyone to really care about information rights and the like. Life’s too short. I don’t know why angels sometimes ask for a board seat when they, for example, do a SEIS round in the UK. I mean what’s there to talk about?
What’s the difference between a SAFE and a convertible note
SAFE has no interest rate
SAFEs are not a debt instrument. Instead, they are more like a warrant. That means they do not carry an interest rate. Convertible debt, however, can carry an interest rate ranging from a 2% – 8% (most falling around 5%).
Let’s face it, investors do not invest in companies to earn an interest rate on loaned funds- it’s chump change. They expect you to get big and earn them bank when you exit. But, for convertible notes to be a debt instrument (and therefore rank higher that SAFEs in a dissolution, meaning shut-down) they need to have an interest rate.
There is no interest accumulation on the SAFE as there is no interest rate.
Convertible notes do accumulate. This only matters when the term is longer than a year, but otherwise doesn’t matter for a short‐term investment. Interest accrual is beneficial for investors for the obvious economic incentives, but it creates an incentive for the founder to get an equity round done sooner rather than later. That’s the theory. It’s still a low-cost loan, so again who cares- you need the money.
Debt vs warrant
I’ve mentioned this before, but to make the point. Convertible notes are like debt. SAFEs are like warrants.
SAFE has no maturity date
Convertible Notes have a maturity date which is typically a year. This can cause some issues when the maturity date comes a knocking. Once you reach the date of maturity, you have two choices:
- Pay back the principal plus interest (if you have enough money to do that), or
- Convert the debt into equity
Paying back your principal is rationally not going to happen if you aren’t doing well (and even if you are doing well!), and investors want their cash back. It would effectively involve shutting down the company and declaring bankruptcy. The reality is investors aren’t idiots. They will extend the term, or if you are doing really poorly, maybe even write off the loan mentally and leave the hope you figure your stuff out.
SAFE is not a debt instrument and, therefore, it doesn’t have a maturity date.
Length of the legal document
SAFE is basically the Cliff Notes of a Convertible Note. That’s both good and bad depending on your level of competence.
If you don’t know what you are doing you can use a SAFE and not have to deal with a lot of technical stuff that investors might know more than you about. You can conveniently gloss over some points.
If however, you know more than / as much as the investor, convertible notes allow you more flexibility to play with things. You need to know what you are doing though. The note agreements are therefore often a lot longer than a SAFE note (Compared to a priced round at least! Everything is relative).
With the new SAFE, investors know almost exactly how much they own (There is dilution when you increase the option pool prior to the S-A round). With convertible notes and the old SAFE you don’t really know, though you can sort of guess a bit in a range.
If you invest 800k on 8m cap (800k/8m), you know you will own approximately 10%. It’s that simple.
Convertible notes are less certain as they dilute one another etc as I mentioned before.
Convertible notes rank above SAFE notes when you shut down. This means if there is any money left it first goes to convertible note investors and then to the SAFE holders. This doesn’t really matter to founders, but it does to investors.
Why is a SAFE better for founders?
As pointed out in the definition, convertible notes can be intricate and lengthy. On the flip side, a SAFE is a 5-7 page document that was created to streamline the seed investment process. Because simplicity is one of its primary goals, SAFE offers a straightforward option. There are only a few things to agree. In the “Safe: Valuation Cap and Discount” there are only 7 things to fill in other than the signature page.
Faster and cheaper
There is less to negotiate, so in theory, the process should be faster to close. You can literally download the SAFE from the Y-Com website and use it as it is. In fact, there is a clause which says:
“This Safe is one of the forms available at http://ycombinator.com/documents and the Company and the Investor agree that neither one has modified the form, except to fill in blanks and bracketed terms.”
The entire point is the doc (other than brackets) are not going to be changed. So if you know basic law stuff you don’t even need a lawyer. But watch out. You need to know how to write things properly.
Here is an example. Are you 100% you know what to type in here: The “Discount Rate” is [100 minus the discount]%.
As I said before, if you do it wrong you really, really messed up!
No interest rate
Convertible Notes have some nominal (or high) interest rate that accrues the longer the loan goes on. This juices investor ownership. Since SAFE has no interest rate, you save a little dilution.
No maturity date
A Convertible Note has a ‘best before date’ of say a year. SAFE has an infinite shelf-life so they only convert when they have an opportunity to do so.
You have to deal with Convertible Notes at some point. This serves to force founders to be accountable to investors and have a discussion near maturity with “what the plan is?”
A SAFE with no maturity date lets you the founder keep raising SAFE notes and indefinitely delay the conversion. This creates a lot of uncertainty for investors (less with the post note), but that’s not your problem. I’m being a little sarcastic here.
No preference overhang
Unless you explicitly add in a clause into your Convertible Note, the investors may get a liquidation preference overhang, meaning they have more liquidation preference than they paid for.
SAFE doesn’t have this issue as it is built in. The preferred stock issued to SAFE investors at conversion has a liquidation preference equal to the amount the investor paid for the SAFE.
Why is a convertible note better for founders?
Control over everything
Y-Combinator created SAFE with the intention of making financing deals cheap and quick to implement. That’s fab in theory. But reality has a habit of getting in the way of theory. SAFE sacrifices flexibility and bargaining possibilities for getting things done simple and fast. More than that, it’s also dilutive in ways you don’t get told. The new post money SAFE are not founder friendly.
Value for money
You don’t really understand these docs. Admit it. Yes, convertible notes may involve a $5k legal fee, but what’s $5k if you don’t get screwed by the SAFEs in future? You’re taking a huge ass risk on setting up a company and you want to save cash on your ownership structure? Dude, come on?
Control over the conversion date
Both SAFE and convertible notes allow for conversion into equity. The difference here is that whilst a convertible note can allow for the conversion into the current round of stock or a future financing event, a SAFE only allows for conversion into the next round of financing when preference shares are issued.
Also, convertible notes typically trigger only when a “qualifying transaction takes place” (more than a minimum amount dictated on the agreement) or when both parties agree on the conversion. The SAFE can convert when you raise any amount of preference shares. This is nice for simplicity, but it doesn’t give control to you.
Another thing to consider is that raising common stock doesn’t trigger a conversion for a SAFE investor, so entrepreneurs in need of some extra cash could do a “friends and family round” and avoid the conversion trigger if there is a need to bridge.
No full ratchet / better anti-dilution
I said above that SAFE are better as they are simpler. That’s what the marketing says. The reality is more nuanced. SAFE come with their own share of baggage now. They used to be founder friendly, now they are investor friendly.
If your pre-money is low enough, the Post SAFE investors get to convert at the price that new investors invest in. That’s basically a full ratchet (that’s bad, if you don’t understand). Y-Com make no reference to this as being a full-ratchet. In fact, this zinger is mentioned on page 22 in an example. You wouldn’t even notice if you didn’t pay attention to the point of building a template (Like I have…). Here is how they introduce their full-ratchet:
In this scenario, Investor B’s safe converted into 10.3% ownership versus the 10% implied by its $8m post-money valuation cap because the Series Seed price per share is less than this safe’s Safe Price. Because Investor B has a pro rata right, it will also be calculated based on this 10.3% ownership.
I shite you not. This is a joke. They are mentioned in the SAFE documents with a cap (obviously).
In fact, the SAFE is worse than a full ratchet. In a priced round, anti-dilution would only trigger if the valuation is lower than the price. SAFE get fully protected from convertible dilution when the valuation cap is higher. Seriously…
The Post SAFE gives investors an extreme level of anti-dilution that you would balk at if you saw them in a Series-A round.
Post SAFEs do not dilute one another / convertibles do
If you issue multiple convertible notes, they dilute each other when they convert. As the post SAFE is on post-money, investors have (fairly) defined ownership. If you give one note 10% and another 5%, that’s 15% dilution. The founders and staff take all the dilution on multiple rounds of SAFEs.
Convertible notes dilute one another, so dilution is shared.
Let’s face reality. The world changed so seed is a phase. Founders use the SAFE to get rounds done quickly in the seed phase. Founders have zero idea how long the seed phase will last and they reach series-A. So all the while they are going to raise multiple ‘seed rounds’. The Post SAFE treat each note as a round, but each SAFE does not get diluted by the next round?! This doesn’t make sense. If each SAFE is a round then why do they not get diluted by new SAFE rounds?
I promise you the math to calculate SAFE are not simple. There is no math reason Y-Com could not allow prior SAFEs to get diluted by subsequent ’rounds’ of SAFE. One improvement would be to fix the capitalization (denominator) in SAFE rounds.
Download the SAFE vs. convertible note matrix
Conclusion on SAFE vs convertible notes
SAFE seem like they are a great concept. The old Pre SAFE was founder friendly. The new Post Note has gone 180 and is now investor friendly, only they don’t tell you that!
If I were you, I would do a convertible note. Yes, you need to spend some money with a lawyer to do your notes properly, but you plan on making a lot of money, right? Why take a bet on SAFE notes to save you some cash and a little time in the short term? You save $5k now and you could lose up to low digit millions in future (If you rock out with your cock out).
Anything you don’t understand or want to add? Let me know in the comments. I would love to hear from you.
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