Convertible Note vs SAFE Agreement: Questions Founders Should Ask

Understanding Convertible Notes and SAFE Agreements

Early-stage fundraising is a crucial step for US startups. Two of the most common tools for raising capital before a formal valuation are convertible notes and SAFE agreements. Both allow founders to secure funding quickly, but each comes with unique legal, financial, and practical considerations. Making the right choice can impact your company's future fundraising, cap table, and relationships with investors.

This article explains the basics of each instrument, highlights their differences, and provides practical examples, state law caveats, and checklists to help founders make an informed decision. Remember, this is general educational information and not legal advice.

What Is a Convertible Note?

A convertible note is a short-term debt instrument that converts into equity in your company, typically when you raise your next round of funding. The investor loans money to your startup, and instead of being repaid in cash, gets shares in the company at a later date, usually with a discount or a valuation cap.

• Debt instrument: Convertible notes are legally considered debt. They have an interest rate (often 4-8% per year) and a maturity date (commonly 12-24 months).
• Conversion event: When your company raises a qualifying priced round, the note converts into equity, usually at a discount (such as 15-25%) to the new investor price, or at a valuation cap, whichever is more favorable to the noteholder.
• Repayment risk: If the note does not convert before the maturity date, the investor can demand repayment of the principal plus accrued interest. This can be a risk if your startup is low on cash.

Example: Suppose your startup raises $100,000 from an investor using a convertible note with a 20% discount and a $3 million valuation cap. If your next funding round values the company at $5 million, the note will convert at the lower $3 million cap, giving the investor more shares for their money.

Federal and State Law: Convertible notes are securities under the Securities Act of 1933. Most startups rely on exemptions from SEC registration, such as Regulation D (Rule 506(b) or 506(c)). You must file a Form D with the SEC if you use this exemption. State law ("blue sky" laws) may also require filings or fees in each state where your investors reside. For example, California requires a notice filing for securities sold to California residents, while Delaware has fewer requirements but is still subject to federal law. Always check both federal and state requirements before issuing convertible notes.

What Is a SAFE Agreement?

A SAFE agreement (Simple Agreement for Future Equity) is a contract where the investor gives money to your company in exchange for the right to receive equity in the future, usually when a priced round occurs. SAFEs were created by Y Combinator in 2013 to simplify early-stage fundraising.

• No interest or maturity date: SAFEs are not debt and do not accrue interest. There is no obligation to repay the investor if the company does not raise a qualifying round.
• Conversion to equity: Like convertible notes, SAFEs convert into shares at a future financing event, often with a discount or valuation cap.
• Simplified terms: SAFEs are typically shorter and less complex than convertible notes. They do not require negotiation over interest rates or maturity dates.

Example: Your startup raises $50,000 from an investor using a SAFE with a $2 million valuation cap. When you later raise a Series A at a $4 million valuation, the SAFE investor gets shares as if the company were valued at $2 million, giving them a better price per share.

Federal and State Law: SAFEs are also securities and must comply with SEC and state regulations. Most startups use the same SEC exemptions as with convertible notes. State rules can vary. For example, New York has specific requirements for securities offerings, and Texas may require different filings. Check state laws for each investor's location.

Convertible Note vs SAFE Agreement: Key Differences

While both instruments help startups raise money before a formal valuation, there are important differences founders should understand:

• Debt vs contract: Convertible notes are debt, with interest and maturity dates. SAFEs are contracts, not loans, with no interest or maturity date.
• Repayment risk: Convertible notes may require repayment if they do not convert, which can strain a startup's cash flow. SAFEs do not have this risk.
• Investor leverage: Convertible note holders may have more leverage if the company struggles, since they are creditors. SAFE holders are not creditors.
• Complexity: Convertible notes can be more complex to negotiate and administer, especially around maturity and default. SAFEs are typically shorter and simpler.
• Tax and accounting: Convertible notes may have different tax and accounting implications compared to SAFEs. For example, accrued interest on convertible notes can affect your financial statements. SAFEs are generally simpler for accounting purposes, but both should be reviewed by a qualified accountant.
• Investor expectations: Some investors, especially institutional ones, may prefer convertible notes for the added protections. Angel investors and accelerators often accept SAFEs.

Practical Example: Suppose your company is unsure when it will raise its next priced round. Using a SAFE avoids the risk of having to repay investors if the round takes longer than expected. On the other hand, if your investors want more security or leverage, they may insist on a convertible note.

State Law Caveat: Some states have usury laws that limit the interest rate on loans. If your convertible note's interest rate is too high, it could violate state law. SAFEs do not have this issue because they are not debt. Always check your state's laws or consult an attorney before issuing convertible notes.

Questions Founders Should Ask Before Choosing

Before deciding between a convertible note and a SAFE agreement, founders should ask themselves and their advisors these key questions:

• How soon do we expect to raise a priced equity round? If you expect to raise a Series A soon, a convertible note's maturity date may not be a concern. If the timeline is uncertain, a SAFE may be safer.
• Are investors pushing for debt-like protections? Some investors prefer convertible notes for the added leverage of being a creditor. Others are comfortable with SAFEs.
• What terms are market standard for our stage and industry? Some sectors or regions have clear preferences for one instrument over the other. For example, tech startups in Silicon Valley often use SAFEs, while biotech investors may prefer convertible notes.
• How will this affect our cap table? Both instruments convert into equity, but the timing and mechanics can impact dilution and investor rights. Use a cap table modeling tool or consult an advisor to see the impact of different scenarios.
• Are there state-specific rules or taxes to consider? State law can affect how these instruments are treated, especially for interest, usury, or securities filings. Delaware is common for startups, but always check your state requirements. For example, Massachusetts has additional notice requirements for securities offerings, and Florida may require a blue sky filing.
• Do we have the right legal and accounting support? Both instruments require careful drafting and compliance with securities laws. Work with advisors who understand startup finance.

Checklist: What to Review Before Issuing a Convertible Note or SAFE

• Confirm your company's incorporation status (Delaware or other state) and update your corporate records.
• Review your state's securities laws and filing requirements for each investor's location.
• Choose the right SEC exemption (such as Regulation D) and prepare to file Form D if required.
• Model your cap table to see how each instrument will affect dilution and ownership.
• Negotiate and document key terms: valuation cap, discount rate, pro rata rights, and trigger events.
• Have your documents reviewed by a qualified attorney and accountant.
• Keep detailed records of all agreements, filings, and investor communications.

Common Mistakes:

• Failing to check state-specific securities requirements, leading to fines or delays.
• Using outdated or non-standard templates that do not reflect current market terms.
• Not modeling the impact on the cap table, resulting in unexpected dilution.
• Overlooking the need for board or shareholder approval before issuing securities.
• Missing SEC or state filings, which can create legal risks for future fundraising.

It is also smart to review the Delaware Division of Corporations for incorporation and compliance information if you are a Delaware company.

Legal and Compliance Considerations

Both convertible notes and SAFEs are considered securities under US law. This means you must comply with federal and state securities regulations, even if you are raising money from friends and family. Non-compliance can result in fines, rescission rights for investors, or problems in future fundraising rounds.

• Federal law: Most startups rely on exemptions from SEC registration, such as Regulation D. You must file a Form D with the SEC if you use this exemption. See the SEC's exempt offerings overview for more details.
• State law: Each state has its own securities regulations. You may need to file notices or pay fees in each state where your investors reside. For example, New York's Martin Act is broad and may require additional compliance steps.
• Accredited investors: Many exemptions require that you only raise funds from accredited investors. The SEC defines accredited investors based on income, net worth, or professional status. Always verify investor status and keep documentation.
• Documentation: Use clear, written agreements and keep records of all securities issued. This is critical for future fundraising and due diligence. Poor documentation can delay or derail future investment rounds.
• Legal review: Have your convertible note or SAFE agreement reviewed by a qualified attorney before offering it to investors. Templates are a starting point, but your situation may require custom terms, especially if you have multiple investors or complex cap table scenarios.
• Tax considerations: Convertible notes may create taxable interest income for investors, and your company may have to report interest expense. SAFEs generally do not create interest income, but the IRS could treat certain conversion events as taxable. Consult with a tax advisor familiar with startup finance.

Example: A founder in Texas raised $200,000 using convertible notes but failed to file the required blue sky notice in Texas. When the company tried to raise a Series A, the new investors discovered the missing filing and required the company to fix it before proceeding, delaying the round and increasing legal costs.

For more information, see the SEC's startup resources and consider consulting with an attorney who understands startup securities law.

FAQs

Are SAFEs or convertible notes better for US startups?

There is no one-size-fits-all answer. SAFEs are generally simpler and have fewer risks for founders, but some investors prefer the protections of convertible notes. The right choice depends on your company's stage, investor preferences, and fundraising goals. For example, if you expect a long time before your next round, a SAFE avoids maturity risk. If your investors want more security, a convertible note may be necessary.

Do both SAFEs and convertible notes require SEC filings?

Yes. Both are considered securities, so you must comply with federal securities law. Most startups use an exemption like Regulation D and file a Form D with the SEC. State filings may also be required. Always check both federal and state requirements for each investor's location.

What happens if a convertible note matures before a priced round?

If a convertible note reaches its maturity date before a qualifying financing event, the investor can demand repayment of the principal plus interest. In practice, many investors will renegotiate or extend the note, but there is a risk of default. This can lead to strained investor relations or even legal action if not handled properly.

Can I use both SAFEs and convertible notes in the same round?

It is possible, but it can complicate your cap table and future fundraising. Using one instrument per round is usually simpler. If you use both, make sure the terms are compatible and clearly documented. Mismatched terms can create confusion or disputes during conversion events.

Do I need a lawyer to draft a SAFE or convertible note?

While you can find templates online, it is strongly recommended to have a qualified attorney review or draft your documents. Small differences in terms can have major consequences for your company and investors. Legal review also helps help support compliance with federal and state law.

Key Takeaways

• Convertible notes and SAFE agreements are popular tools for early-stage US startup fundraising, but they have important legal and financial differences.
• Convertible notes are debt instruments with interest and maturity dates, while SAFEs are contracts with no repayment obligation.
• Both are considered securities and require compliance with SEC and state regulations. Missing filings or using the wrong exemption can create major problems later.
• Founders should carefully consider their company's stage, investor preferences, and legal requirements before choosing an instrument. Model your cap table and review state law caveats.
• Common mistakes include failing to file required notices, using outdated templates, and not understanding the impact on dilution or investor rights.
• Always have your fundraising documents reviewed by a qualified attorney and keep detailed records for future rounds.

Choosing between a convertible note and a SAFE agreement is a key decision for US startups. If you have questions about which option fits your fundraising plans, or need help drafting compliant documents, contact our team at (888) 449-8437 or team@sprintlaw.com. Where legal services are required, they are delivered by licensed lawyers at trusted US law firms through the Sprintlaw platform.