The Founder’s Financing Dilemma: Convertible Notes or SAFEs?

Early-stage companies seeking capital often face significant challenges when seeking traditional financing. Established financing approaches, such as a preferred stock financing or conventional debt, frequently prove impractical for startups.

In response to these challenges, convertible financing instruments have emerged to address the needs of early-stage companies. Convertible notes and Simple Agreements for Future Equity (SAFEs) have become prominent solutions in the startup financing landscape, offering mechanisms that defer valuation determinations while providing immediate capital access.

This analysis examines the structural components, legal implications, and practical considerations of both convertible notes and SAFEs, providing a framework for understanding their respective advantages and limitations in various financing contexts.

Understanding the Instruments

Convertible Notes are debt instruments that convert to equity upon triggering events, usually a priced funding round or M&A exit. They function as loans until conversion to equity occurs.

SAFEs (Simple Agreements for Future Equity) are warrant-like agreements that provide rights to future equity without creating debt. Developed by Y Combinator in 2013 and updated every few years since then, they streamline early-stage investing.

Common Features

Both convertible notes and SAFEs share key mechanisms that make them valuable for early-stage funding:

Conversion Discount: Both can offer investors a reduced price (typically 10-30%) when converting to equity compared to new investors in the qualifying round.
Valuation Cap: Both can establish a maximum company valuation for conversion purposes, protecting early investors if the company’s value increases significantly.
Qualifying Events: Both convert to equity during significant financing events, typically a priced equity round, or an M&A exit.
Investor Protection: Both provide some downside protection compared to straight equity by establishing favorable conversion terms.

Conversion Mechanics: A Practical Example

Startup raises $500,000 with a 20% discount and $5M valuation cap. Later, they raise Series A at $10M valuation ($1.00/share).

Conversion calculations:

Discount method: $1.00 – 20% = $0.80/share → 625,000 shares
Cap method: $5M/$10M = 0.5 price ratio → $0.50/share → 1,000,000 shares

Investors receive 1,000,000 shares (cap method wins), doubling their value compared to new investors.

Key Differences

Where convertible notes and SAFEs diverge:

Legal Structure: Notes can function as debt or can convert to equity; SAFEs are contractual rights to future equity.
Interest: Notes accrue interest (typically 2-8%); SAFEs do not.
Maturity: Notes have expiration dates requiring action upon the maturity date; SAFEs have no time limit.
Accounting Treatment: Notes appear as debt on balance sheets; SAFEs typically appear in the equity section.
Documentation: Notes generally involve more complex terms and paperwork; SAFEs rely heavily on the YC forms.

Pros and Cons

	Convertible Notes	SAFEs
Pros	Familiar to most investors Provide downside protection through debt status Clear timeline with maturity date	Simpler documentation No interest burden No maturity pressure Faster closing process
Cons	Interest accrual increases cost to company Maturity date creates potential forced conversion scenarios More complex documentation	Less investor protection without debt status Some investors may be less familiar with the structure Potential ambiguity without fixed timeline

Making the Strategic Choice

The convertible note versus SAFE decision ultimately hinges on your startup’s unique circumstances and investor dynamics. Consider these final takeaways:

For companies with longer runways to priced rounds, convertible notes provide structure and certainty with defined maturity dates. They may also appeal to investors seeking the psychological security of debt status.

For startups prioritizing simplicity and speed, SAFEs eliminate negotiation friction points like interest rates and maturity dates, potentially accelerating your fundraising timeline.

Remember that investor preferences matter. Some investors often lean toward the familiarity of convertible notes, while tech and West Coast investors, particularly in Silicon Valley, have widely embraced SAFEs.

Whichever instrument you choose, clarity in documentation and transparent communication about conversion mechanics will set the foundation for healthy investor relationships. Given the nuances of these financing instruments and their significant impact on your company’s future, consulting with experienced legal counsel can help you navigate these decisions with confidence. Our attorneys regularly advise founders on structuring these agreements to align with their strategic goals while protecting their interests. Reach out to discuss how we can help tailor the right financing approach for your venture’s unique circumstances.

Disclaimer: This article is for informational purposes only and does not constitute legal advice. For personalized legal guidance, consult a qualified attorney.